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Are your products profitable?: How to nurture your portfolios before the seeds of neglect choke the bottom line. (Cost Management).

What's the cost/benefit of your company continuing to produce a 20-year-old product that it recently replaced with a newer, less expensive version? That's the question I asked one consumer product manufacturer that had not paid attention to the fact that the older product was being sold in low quantities to only two distributors among its nationwide network.

Products like this, as well as services, can be found in every company's portfolio. They are eroding the bottom line because no one makes an effort to look at a product view of profitability. Some executives say that it's the brand manager's job to eliminate poor performers or the manufacturing director's job to flag production inefficiencies. Others simply say, "We've always done it like this?

In part, the problem can be attributed to the inability to review individual product performance in an ERP (enterprise resource planning) system, which is a matter of learning how to structure detailed profitability reports. Yet, better information isn't the cure if organizations continue to make decisions from a departmental "silos" view rather than across the enterprise from a "strategic" view.

As people do with their gardens, companies need to regularly "weed" their current product portfolios by individual SKU (stock-keeping unit) before the seeds of neglect choke the bottom line. Product proliferation can add to business complexity and unnecessary costs, such as growth in inventory due to materials purchasing of nonstandard parts. Rather than relying on others to "weed out" poor performers, senior financial executives need to drive this process by establishing a methodology for tracking and managing product SKUs from a life-cycle profitability viewpoint--also known as SKU portfolio management (SPM).

SKU MAINTENANCE COSTS

How much can you save by eliminating certain SKUs?

Consider the cost of maintaining one SKU among hundreds or thousands in some companies. It can add up to more than $30,000 annually because of a variety of factors. Here are some of the underlying costs to produce one new product a year:

* Manufacturing set-up time;

* Sales and marketing literature development;

* Engineering time to maintain/revise technical drawings;

* ERP system data and routing maintenance;

* Inventory of products, components, and replacement parts;

* Warranty costs;

* Purchasing time.

How does product proliferation impact the purchasing function? In one instance, a move to standardized components and a subsequent reduction of nonperforming SKUs helped a company to increase its leveraged buying and decrease its suppliers from 27 to one. By aggregating purchases, this manufacturer not only gained volume discounts but also eliminated the complexity of managing 27 frequently generated purchase order transactions and corresponding annual vendor contracts.

What does product proliferation do to the ERP system? Imagine having more than 5,000 individual SKUs that undergo constant changes in design, application, authorized suppliers, and pricing. In the exacting dimensions of most ERP packages, each change in an SKU's base characteristics or bill of materials will necessitate a change in the ERP system data master. Managing the dynamics of a large SKU base whose characteristics are constantly changing will add significant time, cost, and data complexities, resulting in significant growth of the Information Systems department budgets over time.

CFOs may feel some foot-dragging from the marketing department at the thought of cutting SKUs, but the loss in sales may be worth the increase in profitability from the shareholders' viewpoint. Consider the following example: A large pharmaceutical company that recently completed an SKU rationalization project trimmed 20% of their existing product line, despite major concerns by the marketing department that they would lose significant market share. The end results: They incurred a 5% short-term reduction in sales while gaining a 60% increase in net profits and a 25% increase in share price. Most of the customers migrated to other, more profitable products that replaced the eliminated products. It was clear the marketing department was more concerned with meeting revenue-based objectives vs. the company's overall bottom line performance. A formal process of SKU evaluation will not only build departmental consensus, but it will help the management team view the entire SKU portfolio in relation to the attainmen t of focused strategic business objectives.

TRACKING AND MANAGING SKU VALUE

What products produce the most value in the garden? How should a company look at SKUs and weed out the poor performers? How can CFOs know if there's a problem with too many SKUs?

An SKU portfolio management process to track product life cycles can help finance work together with marketing and manufacturing to compare products over time to determine which ones to nurture or eliminate. A company's business strategy can be linked to this process and measured with a scorecard for improving the business financially. That way the executive management team has the ability to make solid decisions on what to keep, delete, or standardize.

For those companies with short product life cycles, such as technology-based companies, the process should occur more frequently, say bi-monthly. Companies with longer product life cycles, such as durable goods manufacturers, can track SKUs quarterly or annually.

Here are six areas you need to examine in order to establish an SKU portfolio management process:

Attributes

What is a successful stock-keeping unit? Every company has a different answer based on its marketplace. The idea is to build a hierarchy of attributes and weight them according to importance. Consider using the "Delphi technique," an objective and reiterative consensus-building process, to understand common interests of manufacturing, marketing, and finance. The process requires participants to rank and weight variables independently. Then the individual results are compared to identify congruencies and repeated as needed to derive a clear consensus of priority. It's also important to note that some SKUs have complementary relationships that must be factored into the criteria--e.g., the sales of one SKU may be dependent upon the sales of another SKU, such as accessory products related to a base product.

Some companies may end up with up to 50 attributes, but the team must prioritize and select the top eight or 10 variables that everyone agrees on. Financial and market considerations are two key elements to integrate, and you can examine their relationships as the process begins. Some common attributes in both areas are:

* Financial: profitability, sales, gross margin, warranty costs, inventory turns.

* Market: market share, market share growth, competitive posture, complementary or accessory value, a product's image in the marketplace.

Baseline

What's happening to the company's product line over time? To understand this question it is necessary to establish a current product performance baseline using attributes such as market share, product profit contribution, and complementary sales relationships. Every product should be rated on a 1-10 scale for each performance attribute, the attributes should then be weighted for importance (example: product profit contribution may be weighted heavier than market share), and each product should be scored by the summation of the weighted attributes.

The greater the score for a particular product, the more relevant that product is to the portfolio. An overall mean score can be used to establish the baseline for the entire portfolio.

Here's an example of three products measured by three attributes: market share, profit margin contribution, and degree of complementary sales of other products (e.g., does the product facilitate accessory sales such as a consumer water filtration device that uses consumable cartridges?).
PRODUCTS A B C

Attribute Scores
(weighted score
 in parentheses):

Market Share
(30% weight) 5 (1.5) 7 (2.1) 10 (3)

Profit Margin
(60% weight) 8 (4.8) 2 (1.2) 5 (3)

Complementary Sales
(10% weight) 1 (0.1) 10 (1.0) 4 (0.4)

Total of weighted Scores 6.4 4.3 6.4

The Portfolio Mean Performances Score = 5.7 "Performances Baseline".


Recalculating attribute scores over time will allow the team to identify trends and discover which products are "star" performers. This baseline is also useful for establishing baseline feasibility requirements when the company's designers are developing new product applications--a new product can be compared to other successful products in the portfolio to predict its score and compare it to the mean score of the portfolio. It also guides strategic decisions about the need to either replace or complement a product. In the example above, product "B" may be considered for elimination since it is below the portfolio mean score (4.3 vs. 5.7).

Data Collection

This is a process that may need to be established in your ERP system to gain a product and market data profile by individual SKUs, which is especially important to understanding individual SKU contribution to profitability. In general, data to be collected should accurately represent the attributes selected to analyze SKU performance. Understanding the true profit contribution of an individual SKU may require an activity-based costing (ABC) approach for product-related financial data.

Graphic Models

Graphic models are helpful representations of the portfolio because they integrate the various product attribute scores into visible dimensional relationships. By looking at a product portfolio graphically in various configurations, it becomes easier to build consensus across department lines based on what's important to each group. Over time, competitive influences can be identified.

A waterfall chart can illustrate a company's most powerful SKUs, which are usually the top 20% that produce 80% of the profit. They are typically those in highest demand in the broadest market segments and hold the highest gross margins. Products outside this 20% category may be good candidates for elimination unless the company needs them from a market niche or competitive standpoint. Figure 1 shows a typical waterfall chart that documents profit contribution by SKU. It's evident from the chart that a limited portion of the product portfolio contributes to profits.

Another useful graph is a "bubble" chart, which can be produced with many standard spreadsheet software programs, such as Excel. A bubble chart allows a multiple dimensional view on a two-axis plane by varying the size and shape of individual bubbles. It's useful for comparing multiple attributes. Figure 2 shows a bubble chart (using software from the Atlantis Group) that clearly illustrates a three-year trend focused on financial and market share attributes. The size of the bubbles indicates the magnitude of the product in the portfolio (relative importance in market size, sales volume, and gross profit contribution). Executives can plainly see the emergence of important SKUs to nurture and recognize the losers or SKUs with declining importance.

Management Reporting

A short, graphical, trend-oriented presentation works well for showing SKU financials to executive management. Use some of the graphical models just described (waterfall and bubble charts) along with some specific SKU performance examples. It's also a good idea to provide a pro forma profit-and-loss statement demonstrating the impact of eliminating underperforming SKUs. Most companies that have SKU portfolio management programs in place include this report as standard input to the annual planning process.

Best Practices

Companies that have deployed a successful SPM methodology have integrated it into the annual financial planning process and have adapted their ERP systems to collect and manage appropriate market and financial performance data from an SKU perspective. Marketing and financial managers are required to cooperate in the analysis and preparation of a comprehensive SKU/product plan linked to the projected profit-and-loss statement.

What does your company do best? Over time, an SKU portfolio management process allows companies to identify real key characteristics of success. Decisions can be based on facts vs. subjective criteria. CFOs now have another way to minimize resources and improve profitability across the entire enterprise.

In the case of the manufacturer described earlier, the associated resource costs and subsequent losses caused by carrying older, obsolete SKUs became clear after the company adopted an SPM process. The company discontinued these low performers and reassigned the resources to more productive SKUs, which resulted in an immediate increase in profitability.

Tim Allen is a senior consultant at PRAGMATEK Consulting Group, a Minneapolis-based management consulting and e-business firm. Before Tim began his consulting career, he was the CEO of a $50 million manufacturer of stainless steel products.
COPYRIGHT 2002 Institute of Management Accountants
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Author:Allen, Tim
Publication:Strategic Finance
Article Type:Statistical Data Included
Geographic Code:1USA
Date:Mar 1, 2002
Words:1987
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