I am excited that in this month’s newsletter I am able to share with you some valuable insights and advice from a highly respected business colleague, Fred Silverman. Fred is the CFO of Spectronics Corporation in Westbury and in his “previous life” was a Principal at Janover LLC, a public accounting firm headquartered in Garden City, NY.
The question that I put to Fred is what recommendation would you have for a growing company that wants growth but is having trouble achieving it. As you may imagine many people might immediately identify the answer as “get more sales” but you’ll see from Fred’s astute reply that it’s not quite that simple.
I hope you enjoy the newsletter.
Part I – How to Strategically “Grow” Your Company
The usual avenues to growth are to grow the sales on your current product lines, develop new products or “buy” the sales through purchase of a business. I will stick to organic growth as opposed to growth via acquisition.
I would like to give a caution here about growth that is close to the heart of CFOs at most companies. Growth of sales is not a productive goal by itself. It has to be growth of profitable sales. Many companies are not fully aware of how much net profit (after all overhead) they are making on each product they are selling. Growing unprofitable sales is counterproductive but I believe it happens more often that people might think. The goal is to grow profits and to do that a business needs to analyze the profitability of each of their products. It is not necessary to calculate the net profit down to the penny. Plus or minus a few percent is quicker and easier to calculate and is not significant for this purpose.
The problem with blind sales growth goals can easily be illustrated.
(Example 1)–If a company has $10 million of sales with an overall operating profit of 2.5% of sales they might have $5 million of sales that make a 25% net profit and $5 million that are losing 20% of sales.
(Example 2)— If they grow the $5 million of sales that are losing 20% their net profit will only increase as long as their current resources can support a 50% increase in sales without any increase in overhead costs. That is unlikely and they could do better by replacing the losing sales with profitable sales.
(Example 3)— If they replace that $5 million dollars at a 20% loss with $5 million of sales at a 20% profit they will show no sales growth and their overhead should remain constant. However, their profits will grow by $2 million. They have added profitable sales but dropped the same amount of their unprofitable (or low profit) products. Same $10 million of sales but profit has grown from $250,000 to $2,250,000.
(Example 4)— Be aware that just getting rid of your low or no profit sales will actually make your profits lower if you do not replace them with profitable sales (or significantly lower your overhead). Although a product may have a net loss after overhead, as long as the direct labor and materials cost is less than the sales price those products make a contribution to offset the cost of overhead. Do not get rid of those sales without replacing them or without a proportionate decrease in overhead costs. You will lose the contribution, those products make toward overhead, in example 1 it is $750,000, and you decrease your profits by that amount. If you take our starting income statement from example 1 and remove the losing sales you will move from a $250,000 profit to a $500,000 loss.
In these examples, for simplicity, I have assumed that all overhead is fixed overhead. To more accurately map out your product strategy you should break out your overhead into fixed and variable overhead so you can more accurately see how much the loss of the sales of a product or product line will actually reduce costs. The lesson here is not to set a sales growth goal without carefully analyzing your business and choosing what sales you want to add and also when and what sales you might want to abandon.
Low profit products might be rescued by price increases or decreases in costs through better purchasing or more efficient operations. You should set a net profit percent goal and not vary from it significantly on new products without a very good business reason. New products are a good chance to correct the pricing mistakes of the past that might have been made due to inadequate profit information. Otherwise, even a 1% bump in price should not be ignored. If the company with $10 million of sales increased all their prices by 1 percent and didn’t lose any sales, they would make an additional $100,000 of net profit which a 40% increase in net profit.
Part II – How to Grow Through New Product Development
The road to growth through new and innovative products can be very profitable. New technologies can be patented and prevent competition which erodes margins. The caveat with developing new products is not to spread your research and development resources too thin. You are better off focusing your resources on a few new products instead of a long list. Each new product proposal should be evaluated for profitability, marketability, development costs and time, etc. A scoring system rating each new proposal should be used to eliminate products that seem great at first look but, after closer scrutiny, do not look as promising. Do not fall in love with a product because it has glamour if there is little or no profit to be made after close analysis.
Here is an example that shows the hazards of not focusing your resources on a few very promising products and instead spreading your resources over a larger list. If you have 20 viable projects that each will cost $200,000 to develop you will need $4,000,000 to complete them all. If you only have $500,000 available each year for this purpose, and you start them all at the same time, it will take you 8 years for those products to reach the market. The market could easily have changed in that time and at the 8 year mark you have not made a penny off of those products. However, if you decided to focus on only 2 projects each year you could have 2 of them ready for market at the end of year 1 and continue to bring 2 or 3 to market each year for the remaining 7 years. Those new products that have reached the market sooner can fund research and development to speed up the development of the other products and all products will reach the market sooner and more likely before it changes. The last two projects scheduled to start in year 8 may be abandoned due to market changes. Since you have no money invested in them yet it is easy to do. If you have been developing them over the prior 7 years, you already have a substantial amount invested in them.
Do not grow sales blindly. Make sure you are growing profits.
Growth through new product development can be more profitable than sales of existing commodity products. However, manage your R&D plans strategically so that you are not spreading your R&D resources over too many projects.
Fred Silverman received his undergraduate education at Binghamton University and his MBA from Hofstra University. He is a CPA licensed in NY and was a Principal at Janover LLC. In Garden City , NY until this year when he turned away from the dark side of public accounting and went to work as the CFO of his longtime client Spectronics Corporation in Westbury, NY.
For more details regarding this subject, you can contact him at Fred.Silverman@spectroline.com.
November 1, 2016