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BUSINESS BRIEFS: Thinking Outside the Box

December 1, 2008
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In my years as a ceramic engineer and general manager of a small refractory company, I watched many of my competitors fall into bankruptcy and disappear from the American manufacturing landscape. The list is long, and the impact on their employees is sad. And yet, in most cases, it didn’t have to be. The managers of those failed companies had the solution to their financial woes right in front of them, but apparently just beyond their reach.

The phrase thinking outside the box has always intrigued me. It’s catchy, but what does it mean? What is this box that we are supposed to think outside of? Simply put, the box represents our preconceived notions, our prejudices. We need to cast off what we believe for what we think. Thinking becomes the key word because when we think-there is no box.

Let’s look at some specific situations that caused the unnecessary demise of some unnamed refractory companies. They remain unidentified for obvious reasons, but the situations are real. If your company is experiencing a similar situation, the case studies presented may be helpful in resolving your difficulties.

Figure 1. This company must operate at within its market capacity, which is below the break-even point.

Money or Margins

The goal of a business is to make money, not margins. Yet many managers insist on achieving some arbitrary profit percentage, even in the face of declining sales and profits. They fail to recognize that in some situations, less is more. Lower profit margins can generate more profit dollars.

Figure 1 illustrates this concept with a break-even chart for a very real company that was making small refractory fixtures. Most managers are familiar with the break-even chart, which illustrates the relationship among revenues, fixed costs, variable costs, plant capacity and profits. What is missing from most of these charts is the rarely recognized concept of market capacity. In Figure 1, market capacity is included.

Since most companies have competitors, they must share the market for their products with those competitors. While market share is dependent on many factors, one of the most influential is price. Price determines both the revenue line and the market share. Your market share defines your market capacity, which defines your operating range on the break-even chart. The company illustrated in Figure 1 must operate within its market capacity, which is below the break-even point. It’s losing money, but it has a healthy profit margin.

Figure 2. The company’s break-even volume would have increased had it decreased its pricing.

The profit margin is the difference between the slope of the total cost line and the revenue line. The slope of the revenue line must be greater than the slope of the total cost line. To be considered a “healthy” profit margin, the difference must be great enough to achieve break-even before the plant reaches its capacity. However, that traditional analysis fails to consider market capacity.

In order for this company to succeed, it had to expand its market capacity. By keeping track of the orders it had lost because of high pricing, it was aware that a price cut would yield a significant increase in volume. If it had made that cut, its break-even chart would have looked like Figure 2. The total cost line would have been essentially the same, but the slope of the revenue line would have been significantly reduced. This would have increased the break-even volume.

However, the lower price would also have increased the market capacity to levels approaching plant capacity. Since the break-even line would have been in line with market capacity, the company would have been profitable. It would have exchanged margin for money. Unfortunately, this company did not make those price cuts, and it suffered the consequences.

Figure 3. This company is operating with market capacity at its maximum.

Space Wars

In the era of mass marketing, the tunnel kiln was a wonderful development. Today, the prevailing market strategy is segmentation. The market is no longer a mass; it is a collection of viable segments, each with its own character and demands. If you are an old-time supplier with a big plant and a long tunnel kiln, as the company in this example was, you might find yourself slumping toward bankruptcy as the volume in your plant dwindles.

Figure 3 is essentially the same as Figure 1, except the market capacity is at its maximum. Lowering price will not affect it because this company was already the low-price producer. Because it was locked into the tunnel kiln, this company had very little firing flexibility, which limited the range of new products it could develop. In short, it was a big old dinosaur on the verge of extinction.

The company had fought a good fight. It cut prices, employees, material costs and management/marketing staff. Management had even committed to running the tunnel kiln intermittently, three or four times a year, with enough partial and dummy cars to extend the run and dilute the startup/shutdown costs. But that tunnel kiln and plant were simply too big for the available business. It was just a matter of time…or was it?

Figure 4. The company adjusts its product and employee flow from a  continuous to a batch operation.

Where big had been a disadvantage, we decided to make it an advantage. Since the core of the plant was the tunnel kiln, we decided to design the operation such that it operated at peak efficiency. No more partial or dummy cars. We would use the space in that big plant to fill the space in that big kiln. In essence, we converted the plant from a continuous operation into a batch operation.

The workers move with the product, creating surges that can be easily accommodated by the excess floor space in the plant. The kiln operation is still intermittent, but the surge of people and products shorten its run time and increase its efficiency. The net effect is an energy cost savings of more than $130,000 a year. The result is illustrated in Figure 4.

Table 1. Return on assets for select industries (based on the financial reports of publicly traded companies within the industry).

Invest for Success

Most companies have instituted impressive capital allocation policies. They have established rules to determine what capital projects can be implemented and which ones will be rejected. An often-quoted number is a 45%: If a project is expected to achieve a 45% return, it is accepted. Anything less is rejected.

Given that a company’s capital budget often exceeds its annual depreciation expense, one could reasonably expect that any company, within 10-12 years, would ultimately achieve a return on total assets of 45% or higher. Unfortunately, that is not the case. The average return-on-assets for select industries is presented in Table 1, and it is dismal.

Capital projects basically fall into two categories: cost reduction and sales expansion. Each type compares an outlay of capital funds today to a generation of additional profits tomorrow. And while uncertainty and timing plays a role, a key factor in the failure of a project to meet its return requirements is structural. Some projects simply do not account for all the costs associated with them. Let’s look at two simple examples.

Cost Reduction
In this example, a capital outlay of $50,000 is expected to reduce labor costs by $25,000, yielding a 50% percent return on investment. If the company was earning 10% on $1 million of assets, this project would improve that performance to 11.9% on $1.05 million of assets. Sounds good, but is it?

Let’s assume that the company is paying its workers $50,000 per year. The above savings would represent one-half of an employee. Is the company actually going to lay off half an employee? It is more likely that the project will be accepted, the money will be spent and the employee will be retained. The company will find something for him to do, and the effect will be that the company does not save $25,000.

The savings look good on paper, but they are not real savings. The result is that the company is not earning an 11.9% return. Instead, it is earning just a 9.5% percent return and is worse off with the capital project because it did not make the savings real.

Sales Expansion
In this example, a capital outlay of $50,000 for a new dry press is expected to generate an additional $25,000 in profits. Like our cost reduction example, this purchase should provide a 50% return on investment. All things remaining equal, the new return on assets for the company will be 11.9%. What could go wrong here?

Let’s assume that in order to generate that $25,000 in profits the company must sell $100,000 of additional product. That level of sales must be supported with receivables and inventories, which are capital expenditures. Assuming 60 days for each, that is an additional capital outlay for receivables of $12,329 and for inventories of $9246. Assuming there are no additional production line investments to support the new press, the new project return is just 34.9%, and the overall impact on the company falls from 11.9% to 11.7%. Not as bad as the cost example above, but still not what was expected. It is vital to include all of the capital needed to realize the potential gains.

The impact of a poorly structured capital expenditure is not going to bankrupt your company tomorrow, but it is, over the long term, going to weaken your financial performance. And more importantly, it will cause you to develop some poor business habits that could lead to poor business decisions. When it comes to capital expenditures, consider all of the costs and make the savings real.  

Increase Those Profits

When I was managing a small refractory company, I had a plant that was generating $2 million in sales but no profits. The plant manager told me that he needed more sales, and I exhorted my marketing people to get those sales until I read an article in The Wall Street Journal. The article stated that the average McDonald’s restaurant generated just $1.4 million in sales and more than 25% profit.

It struck me that if they could do it, we could do it-and we did. Our plant went from $2 million in sales and a loss to $2 million in sales and a 25% gross profit. You can do it, too. All you have to do is step out of the box.

Any views or opinions expressed in this column are those of the author and do not represent those of Ceramic Industry, its staff, Editorial Advisory Board or BNP Media.

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