What Price Profit? Profit and loss: what an interesting concept for the operations executive. Prior to the currently trendy effort to establish activity-based costing accounting allocations, operations and fulfillment managers relied almost solely on the fictitious beast affectionately known as the profit and loss statement. I suppose that most prudent operations executives, given a corporate goal of establishing profits or losses from operations, would tackle the challenge from a number of possible attack positions.
Wow, profit centers One customer-direct supplier began to resell empty outbound trailer space to generate revenue from operations. The logic presented to the operations team was that each trailer left approximately 77% full, and that the financial group would like to reap the benefit of filling the remaining 23% of trailer space with LTL freight from eager regional shippers.
After the first year of selling trailer space, and after paying a freight reseller $40,000 to manage the use of the empty space, the company made a net revenue from operations of $2,436. Wait, after the two hours it took me, as the company consultant, to calculate the effectiveness of this endeavor, that net went down to $1,536. But if we are selling inefficient back-hauls, shouldn’t we first figure out how to eliminate them altogether?
At a national retail department store chain, I was told proudly, “We charge our vendors back for the cost of all our operations and any unanticipated work that we incur. As a result, our distribution centers have become profit centers.” Wow, profit centers.
Fortunately, I was involved in developing a strategy for this retail chain and was able to compare it to its competition, for which I had also done strategic work. The chain’s “vendor-compensated” operations costs were a full 10% to 20% higher than its major competitor’s operations costs, but the company’s cost of goods sold was 2% higher than its major competitor’s COGS. Not only was this retailer not watching the shop, because “the vendor paid for it all,” but its vendors were charging a cost-of-goods premium to compensate for the charges the retailer had levied on the vendors to begin with.
The game to beat I remember fondly the wise counsel I received early in my career from the CEO of an auto-parts chain. As a young entrepreneur, this CEO had sought to maximize his margin on windshield washer fluid during the winter months. He regularly requested, year after year, that the windshield washer fluid supplier cut his cost by 3%. Each year the supplier would gladly comply, and each year, the young entrepreneur would watch the unit margin rise and overall sales fall. Finally, after five years of falling sales, the young man asked his supplier why he complied with the reduction requests. Whereupon the astute supplier replied, “Each year, I reduce the amount of cleaner that I introduce into your washer fluid water.” Remember, the supplier is always better at the shell game than the purchaser.
There is much to be said for generating revenue from operations. In fact, when looking at the bottom line, I would rather generate $1,000 in revenue from operations than generate $1,000 in sales. In “selling” $1,000 in merchandise I have to address the windfall in terms of what I had to expend to make the sale. I must first subtract the cost of goods for that $1,000 in merchandise that I had to purchase, say $360. Next, I have to subtract the cost of operations to deliver that $1,000 in merchandise, say $25. Finally, I have to subtract the cost of the sales, administrative, and general costs that our company incurred to bring in and administer the purchasing customer, say another $125. This means that I contribute only $490 to the business for each $1,000 in merchandise that I sell.
On the other hand, if I sell empty trailer space, I spend nothing more than I would have spent to begin with for the most part, but I reap a full $1,000 for the bottom line of the business. Yes, I should quit selling merchandise, which generates a mere 49% margin, and focus my efforts on the generation of revenue from operations, which brings me close to a 100% margin.
Judgment day The problem lies herein: We recouped this $1,000 from costs that we probably should not have been expending in the first place. This example is much akin to having our kids come back from shopping and inform us how much money they saved by paying for earrings and body piercing at the shop that charged $3,000 rather than at the store down the street that charged $3,800. We made 100% margin on that $800 in savings. Boy, are we glad.
Of course, in every operation inefficiencies exist that are an inescapable reality of the business and that can creatively be brought to bear to provide a revenue stream. So how does the cautious operations executive determine the difference between recouping inefficiencies by reaping revenue from operations and removing the inefficiencies altogether? Below are a few hints that can help in making this critical judgment.
Judgment 1: First, focus on your company’s core business and do it right.
If you are a direct-to-home supplier of groceries, it’s not enough to know just the business of perishable sales. You must know the business of high-service home delivery as well. Remember, you are selling home delivery services as well as perishable groceries. Do both of these things correctly. Once customers are satisfied on both counts, then begin to search for opportunities to cash in on inefficiencies in operations.
Judgment 2: If an activity is not your core business, let a third party do it.
If you are busy conducting zone-skipping line-hauls and chuckling as you back-haul those empty trailers that have bypassed so much in parcel fees, then you probably should let those who do line-hauls as a business do the line-hauls. Most third-party carriers are able to absorb the empty trailer at the remote hub and use it for their business. You may incur 18% in premium over your internal costs, but you will defer the 50% in back-haul costs spent in conducting zone-skipping shipping incorrectly.
Judgment 3: If you have dormant operations capacity from which you are attempting to reap operations revenue, attempt to get rid of the dormant operations capacity first.
This, of course, is not always possible. I reviewed the operations of a very large direct-to-customer supplier of fashion apparel. Because of the peak-to-average swings of the business, much of the merchant’s operational capability lay dormant for the non-holiday period of the year. This company determined that it could not divest itself of its dormant equipment and space during the off-peak time and attempted to offer this capacity to a complementary off-peak business. Overall, the operation reaped a 0.2% offset of operations expenses from revenue from operations. It is frequently impossible to identify the distraction to management that these outside operations may inflict. Often it is helpful to view dormant facility square footage as an investment in peak business, and concentrate on dormant labor and overhead as the real target of reapplication in low-demand periods. From this standpoint, and for the overall benefit of the employees involved, it is better to utilize workers’ time more wisely than to focus on the utilization of the four walls around them.
Judgment 4: Charge back your vendors only for mistakes that unexpectedly cost you money and not for the costs of conducting ongoing, normal, everyday business.
Most suppliers will own up to mistakes in packaging, packing, marking, or labeling, and will offer itemized recourse to the loyal customer. Broaching the idea of charging for ongoing operations introduces a whole new business mindset. Whatever a vendor expends to conduct his business to support you, he will charge back to you along with an SG&A and margin tacked on. Don’t fool yourself or your CFO – if a vendor is the top supplier of drink coolers, then help him stay focused on remaining the top supplier of drink coolers. Don’t lead him into becoming a specialist in store or distribution center delivery on your behalf. Not only will he charge you a premium for the service, but he may begin to use the newfound delivery capability that you are paying for to deliver cheaply to your competitors as well.
Judgment 5: Never accept any “free” service from a supplier unless that service comes at a lower price than what would you would have to pay to do it yourself.
This is possibly the most widely ignored tenet in operations and fulfillment, but in fairness, it is also the hardest issue about which to derive direct cost data to support decision making. Free delivery. Free carton packing. Free freight. Free value-added services. Nothing is free, and if it is free, someone, somewhere, had to pay for it, hopefully not you. When examining the logistics supply line, establish the cost involved in all value-added actions that take place along the supply chain. Each action will have a place and cost structure in which it is conducted most efficiently.
I have worked with a major pet supplies direct-to-customer client who was serviced by a leading pet food supply company that conducted all distribution center deliveries through its own delivery network. This supplier insisted that the service was “free.” But because my client was indeed the largest customer of this pet food supplier, the only customers receiving “free” deliveries were smaller competing customers who reaped the economies of scale that my larger client was footing.
Many of our top customer-direct suppliers and fulfillment companies still use the format of the traditional profit and loss statement to record operational expenses internally. Despite the popularity of this device, however, it is wise for us to not get carried away with the broader meaning of the P&L concept. We should instead think about what we, our suppliers, and our servicing carriers do well. Once each entity in the supply chain is core-competency focused and directed, then let each participant in the supply chain do what it does best, in the best fashion it can. Then, and only then, can we begin to examine dormant capacities and inefficiencies for the possibilities of positive profit and loss impact.