Why you must crop your products: if you want to cultivate your bottom line, try trimming your product line.

In the most recent annual report of a large consumer products manufacturer, the company explains it added more than 200 products during the fiscal year. It also stresses its focus on new-product development. But it says nothing about retiring any of its existing products. Assuming, therefore, that few - if any - of the firm's products are headed for retirement, it's very likely that unmanageable complexity and increasingly bogged down operations will mar the company's future results.

The company also will probably find it harder and harder to schedule, make, manage and deliver a full product lineup. A steadily increasing variety will clog the process and even result in cannibalizing demand for other products, thereby reducing returns on all products. Written between the lines of the annual report is evidence that this is already happening: The company says its average revenue per stock-keeping unit, or SKU, is less than 20 percent of the average revenue per SKU of several competitors (and it's not enjoying premium pricing for its products). Sound familiar? If it does, you're not alone. When Financial Executives Institute and Computer Sciences Corporation asked financial officers how they grapple with today's toughest information-technology issues, the two areas where CFOs feel most limited by a lack of enabling technology are measuring product and customer profitability and reducing enterprise operating costs. (The results of the study appear in the "1998 First Annual Survey of Technology Issues for Financial Executives," a joint FEI/CSC publication.) And one issue that relates directly to both concerns is the process of "rationalizing" products, services and customers.

Resources to the Rescue

In recent years, many companies have launched initiatives to bolster their operations. By enhancing business processes that focus on developing, producing and marketing new products and services, many have enjoyed market growth. Too often, though, the market growth hasn't been followed by improved financial performance. In effect, companies fail to grow profitably.

While many potential reasons exist for no-profit or low-profit growth, a key factor is neglecting to regularly analyze product and service profitability - and subsequently failing to retire products, services and customers from which the enterprise can't generate acceptable returns. This analysis and cropping cycle is often called "rationalization," a systematic process that helps companies evaluate products, services and customers; identify those that aren't producing targeted returns; implement programs to improve performance; eliminate those products, services or customers from which you can't raise returns to an acceptable level; and redirect resources to more profitable endeavors.

In many ways, the rationalization process is similar to pruning a tree. The best growth occurs when old, dying and low branches are cut away to reduce the drain on finite resources. This allows more nutrients to go to the highest and greenest branches the ones that gather the most light and, thus, are best positioned to sustain the tree. Similarly, a company continually must renew itself by freeing up organizational and physical capacity to support new or more profitable products and customers.

But if your company does undergo rationalization, you must do so on a scale sufficient to redeploy freed-up resources so they support other products and customers. Without this level of pruning, rationalization likely will result in revenue reduction only - and give you no ability to affect the expense or asset base of the enterprise. It's like pruning just one branch: Your ability to provide additional nutrients to support new growth would likely be negligible.

Special Orders

An annual report from a large chemical manufacturer provides another good example of what can happen without a working rationalization process. Here, the company says 50 percent of its products generate 97 percent of its revenue. This means, of course, the remaining half generates just 3 percent.

Why the enormous disparity? During a recent period when its market was depressed (and the company was desperately seeking new customers and additional revenue), it agreed to develop numerous special formulations. These same products (and the resulting new customers) now limit the company's ability to pursue attractive business during good market conditions. The special formulations are produced and sold in much smaller quantities than the larger-volume commodity items. And these low-volume items cost more to produce. Since many overhead costs relating to a sales order - like scheduling products and servicing customers are volume-independent, far greater product costs and costs-to-serve exist on low-volume orders.

The manufacturing area incurs additional penalties relating to low-volume items. For instance, this chemical company historically enjoyed long runs of its primary products, as well as the ability to blend in off-spec products made during transitions between formulas. As products proliferated, it shortened production runs for its base products and added more low-volume orders to the weekly schedules. Transition material and transition time became a significant portion of the overall capacity.

Furthermore, the company was experiencing an increase in off-spec material as the shorter runs - before and after the transition provided less opportunity to blend in the off-spec products made during a transition. Since the high costs incurred for these low-volume orders weren't reflected in their pricing, the amount of capacity and other resources consumed on the low-volume orders dragged down overall profitability and significantly reduced the firm's return on assets.

Similar rationalization issues occur in service organizations. For example, the banking industry is undergoing rapid change driven by deregulation and technology. Deregulation has allowed banks to merge and thereby expand their financial capabilities, while technology enables them to exploit new distribution channels. In turn, these changes drive an increase in product specialization. While banks focus on growth and client service, most aren't rationalizing their existing offerings. But banks, like manufacturers, must rationalize their products, services and customer bases so their resources in sales, marketing, administration, operations and systems can support their most profitable products and customers.

Doing It Right

Now look at a company with effective product- and customer-rationalization processes. As it adds new products and customers, this organization evaluates returns by product and customer, and identifies those that are underperforming. The company then considers how it might retain products and customers while improving returns. When raising the return to an acceptable level isn't practical, it looks at an exit strategy. Finally, the company redirects freed-up resources toward its more profitable product lines and business segments. Like this organization, companies with tightly defined rationalization processes experience more profitable growth, higher returns on assets and market valuations that appreciate more rapidly.

A recent cover story in Business Week describes how Procter & Gamble and other large consumer goods companies are rationalizing their product lines to achieve more profitable growth. The article notes that P&G's product list has been reduced by a third compared to 1990, while its sales have grown by a third in the last five years.

To be that effective, your company's rationalization process must observe three key tenets. First, you must position rationalization as necessary and recurring. If rationalization occurs only when your firm is overwhelmed by proliferating products and customers, you've probably missed opportunities and misdirected internal resources. Failing to remain in peak competitive condition is risky in today's marketplace. It's akin to waiting until after a heart attack to change your lifestyle.

Periodic rationalization will help keep your products and returns flowing. The frequency of your rationalization reviews depends on your frequency and amount of new product introductions; the lifecycles of your products and services; and the profiles and lifecycles of your customers. In simple terms, the frequency of rationalization should match the rate of change in your business.

Second, you should always use fact-based measures of returns. Typically, traditional costing and profitability-measurement methods consider only manufacturing costs. They ignore those costs you apply before and after manufacturing, as well as your investments in infrastructure, such as inventory, receivables and equipment and facilities. Your evaluation of economic returns must put aside GAAP accounting and consider all the resources you consume that relate to customers and products. Likewise, your evaluation must explicitly consider all significant variables that drive differences in resource consumption.

For the typical manufacturer, these variables include factors such as changeovers, process speeds, yields, product volumes, demand variability, inventories, ordering practices, distribution services and customer payment practices. In a service business, some variables will be similar to manufacturing; others won't. In both company types, the evaluation must include costs incurred during the complete lifecycle of the products and the customer relationships. In other words, each factor that would have a measurable impact on your returns should be part of your evaluation.

Third, you must identify all relevant strategic and operational considerations. As with any process, your rationalization decisions must support your overall strategic objectives and be executed in an orderly manner. If, for instance, your company emphasizes product innovation to drive market share and returns, you'll want to eliminate older items quickly. If customer intimacy is your market-share driver, you probably should retain some less-profitable items to maintain key customer accounts that, overall, are very profitable. If your company focuses on operational excellence, you'll need to control variety to maintain a low-cost position, and thus will emphasize products where there's a significant market demand and the company is cost- and profitability-advantaged.

When certain products and customers produce lower-than-desired returns, the first step prior to considering rationalization is to identify ways to improve their profitability. The remedies include product redesign, process improvement or redesign, price increases, outsourcing and customer service negotiations. If improving the return isn't practical for your firm, your strategic considerations may still dictate retaining certain products or customers. In an "up" market, for example, companies in cyclical industries might keep some less financially attractive items because demand for them is stable over the full business cycle.

Retirement Planning 

As part of your strategic analysis, you must also consider relationships among products. Complementary relationships may prevent you from immediately eliminating some items targeted for retirement. For example, you may need some variety to obtain or maintain store shelf presence, since a lack of shelf presence could hinder the sales of some profitable items. In some cases, you'll need to define groups or families of items as the "product." And when items become candidates for elimination, you should consider methods to mitigate your revenue loss, such as shifting demand to similar products.

Once you make the decision to eliminate products and customers, your firm must develop marketplace and operational exit strategies; that is, you have to consider the impact on your customers and your competitive positioning, as well as on your own operations. Your strategies should include phasing out items and customers in an orderly fashion, which may entail advance communications with certain customers to explain the upcoming changes and to help them through the transition. You'll also want to synchronize your rationalization actions to manage your supply chain inventory; replace discontinued items with existing similar items or new products when possible; and manage specific customer issues such as contractual agreements.

You also should develop plans to redeploy any existing inventory - raw materials, work-in-process and finished goods - and stop further procurement and production for these items. Plus, you'll need to evaluate the impact of your rationalization decisions on your firm's physical capacity and other resources to ensure that you redeploy the freed-up resources toward profitable growth. Remember, your rationalization must be of sufficient scale to allow you to redeploy the newly available resources to support other products and customers.

Finally, because the rationalization process requires the support, input and coordinated actions of the entire organization - development, operations, sales and marketing, and finance - as the CFO, you must enlist all members of senior management to drive the change.

A recent story in Marketing Management notes, "The typical American supermarket grew from 7,000 stock-keeping units in 1960 to over 30,000 SKUs by 1995." And, according to Market Intelligence Service, Ltd., about 25,000 new packaged products were introduced last year, and nearly 21,000 the year before that.

Given these daunting numbers, it's clear that businesses must strive for sustainable, profitable growth, and that processes to support that growth must include the aggressive rationalization of products and customers. Retiring products and customers shouldn't be a one-time, crisis-driven exercise; it should be a periodic, recurring process you conduct as your business undergoes change. You should base your rationalization decisions on the economic value of your products and customers and recognize their role in attaining your strategic objectives. Your exit strategy should address both the marketplace and operational requirements to abet an orderly transition.

If your rationalization process is effective, you'll ensure that your enterprise continuously employs its resources in support of its most profitable products and customers. As a result, the process will also protect and enhance your firm's competitive position, market valuation and most of all, its ability to grow profitably.

Mr. Boltin is a partner with the National Supply Chain Practice at Computer Sciences Corporation, where he leads the financial management consulting specialty. You can reach him at [phone]. Ms. Gorneau is a principal with CSC's National Supply Chain Practice and also is in the financial management specialty.