It is not easy to convince stock market analysts and shareholders that the best path for a public company is to shrink revenue and choke production output. How could falling revenue and output ever be a good outcome for a profit-focused company?

Yet sometimes when companies find themselves systematically buying capacity only to use it to produce products or services which are then sold at a loss, deactivating and removing underutilized assets as well as reducing output not only results in improved profit, it also results in lowering revenue.

 

Contraction is Failure for Some Companies

For companies, Growth (Revenue per Share) is a key performance measure. There are no prizes offered by the stock market for reporting negative rates of revenue growth in any industry.

Falling revenue is generally interpreted as a sign of failing business fortunes and/or a vacuum in business strategy. Share prices tend to dive in response.  

There is no doubt that our financial and economic systems value growth. It is tough to convince most economists that the best path for a nation is to endure periods of flat or contracting Gross Domestic Product (GDP). Invariably, fiscal and monetary policies are designed to stimulate consumption and sustain output whenever growth is threatened. Indeed, in capitalist societies, we define broad-based economic hardship as ‘recession.’ Recession is defined as two consecutive quarters of negative GDP growth. ‘Depression’ is defined as a severe and prolonged recession.

Like share prices, if we think of a currency, or the assets held within a national economy as being the equity we hold in that economy, ‘recession,’ and ‘depression’ do tend to reduce the value of currencies in economies subject to recession relative to those that are not. One reason this happens is because the monetary policy applied to end recessions generally results in lower domestic yields on debt and increased liquidity. The cost of debt is reduced.

So, we know that with some exceptions, contraction in company revenues is not good for share prices and economic contraction is not good for currency values.   

For global economies, economists have elevated GDP growth to the zenith of economic performance metrics. How could low growth, recession, or depression ever be good for a nation? Most believe that recession is the result of failed economic policies. No Chairman of the Federal Reserve Bank or serious politician would ever lay claim to pursuing such an event or to having caused one.

Do some profit-focused businesses abrogate their responsibility to shareholders and seek to sustain revenue and output at the expense of reduced earnings?    

Margin Sacrifice: A Strategy to Sustain Revenue and Output  

Margin sacrifice is the practice of reducing price and profit margin to attract market share from competitors or exploit the price elasticity of demand with the objective of maintaining output and the level of activated capacity. It is not a strategy focused on improving profit outcomes.

It results in the radical reduction of profit margins and a significant portion of productive capacity being directed towards the production of output which is loss making (Unit Profit = Price – [Unit Fixed Cost + Unit Variable Cost]).

Margin sacrifice typically coincides with the failure of demand forecasting, planning, and resource matching functions and disciplines. Managers who are not compelled to vary productive capacity in relation to fluctuating demand may instead turn to margin sacrifice as a means to load excess capacity with production.

Logistics and Supply Chain functions may act to facilitate margin sacrifice by brokering and shopping excess production capacity throughout regional operations and liaising with regional Sales and Customer Service functions to obtain additional production volume using discounts, rebates, preferential service levels (e.g. reduced minimum order quantities) and extended payment terms. 

Loading excess capacity is not necessarily achieved using up-front discounting and rebates through the Sales function. It often follows the creation of excessive inventories which wind up being pushed out the door using discounting or promotional pricing. Alternatively, these inventories may have their value ‘written down’ or ‘written off’ during subsequent reporting periods. Write downs represent ‘non-cash costs’ in current reporting periods but were reflected in higher operating expenses (lower margins) during the reporting periods in which the products were originally produced.   

Margin sacrifice is employed to preserve existing levels of activated capacity because it easier than sustaining the management disciplines required to adjust activated levels over the short interval.

Responsibility for the sacrifice is often obscured over time and across functions. Production function may fail to vary activated capacity over time, but are not directly responsible for sacrificing margin themselves. This is passed off across the functional divide. Responsibility is diffused. No one in employment may be able to say exactly why excess inventory was originally produced over months or years. The decision that it should finally be written down in value is usually perceived to be an error without an owner.

The problem for demand managers and resource planners is that past sales volume is the basis for forecasting future sales volume when applying demand forecast algorithms. If loss making demand is conjured up in history by sacrificing margin, and then real capacity is spent to meet that demand, forecasting algorithms ensure that the demand so created is reflected in future forecasts. The business thereby creates demand, satisfies it, forecast it in future and plans to hold sufficient capacity to do so.

All the functions will effectively cooperate to rinse and repeat. Margin sacrifice is systematized.

Not surprisingly, we have found in these circumstances that the demand profile often ends up approximating the level of activated capacity held by default. At some point, local management may seek to abandon forecasting and Sales and Operations Planning disciplines, arguing that the disciplines are redundant because demand is demonstrated to be consistent or flat. Ironically, historical production volumes are self-fulfilling and will confirm their claim because the demand profile has been matched to activated capacity levels using margin sacrifice.

The chicken and the egg are confused with each other in the fog of history.

Flattened demand, lower prices, and thinner margins may become the new constructed reality. Thin margins can overtake entire industries in this way. Companies may systematically sacrifice margin to the point where a large portion of output is effectively loss making and a large proportion of activated capacity (often over 25%) is effectively wasted.

That is the Pygmalion Effect acting in resource planning functions.

Standard Margins and Reporting Margins as Averages

After the fact, margin sacrifice may be obscured by averaging margins over time and across products/SKUs or within a product across individual invoices in reporting. Management may, for example, require that Standard Margins average a minimum of 20% EBIT. While this average may be realized over the course of a month, an inspection at the level of individual invoices for a product or product family may reveal that 30% of all units produced were sold at a unit loss while others exceeded 20% significantly. Ongoing audits of this type are essential.

Lower average margins are often attributed to the ongoing need to deal with uncontrollable competitive factors. Once customers are conditioned to the price variability being offered, salespeople may believe that price outcomes were simply the best that could be achieved ‘under the circumstances.’ However, these will be circumstances created where margin sacrifice has been employed to generate incremental sales volume. A detailed historical analysis at invoice level will confirm whether the cause was competitive pricing pressure or if margin is being sacrificed to load excess capacity.

Salespeople often have no real idea what competitor prices were during history and in many businesses, customers may rarely talk to Sales representatives directly. Often, they interface with Customer Service Functions to place orders only. Many Sales functions have no working knowledge of how customers may break up their order patterns across competing suppliers to take advantage of margin sacrifice. Customers act in their own interests and take advantage of margin sacrifice practices. They learn and grow to expect the timing. They may wait for lowered prices to place their orders. Once a price is given, it becomes a future expectation. These are the ‘circumstances’ to which salespeople may be referring.   

Producers of consumer goods and services, including financial products, rationalize these practices with the notion that their fixed costs were already ‘sunk’ and that incremental sales volume is therefore profitable at any price above variable unit cost.

This is an accounting fiction. While the fixed costs of excess production capacity are ‘sunk,’ they are not fully utilized. The act of fully burdening all units of production with the entire amount of fixed costs results in the accounting fiction that all production assets were fully utilized. However, profitable demand can be met with lower fixed and variable costs.  

Margin sacrifice also applies very much to commodity businesses. While miners and processing businesses do not have direct control over global commodity prices, they effectively practice margin sacrifice by producing output which is unprofitable at current commodity prices. Alternatively, they act to rationalize mine designs and parse marginal or uneconomic reserves only after a considerable lag time, or as a last resort.   

Reevaluating mine design and paring back production plans to avoid producing unprofitable output requires dynamic management of short term production planning. It is the first step in optimizing throughput. That’s not easy. It requires variations in short term resource levels and the amount of activated capacity. It is hard work for management. 

However, systematizing these dynamic relationships may sustain, or at least, slow the reduction of profit in tight commodity markets.

Throughout the 1960’s and 1970’s, US Capacity Utilization ran around the 90% level.  In April 2017 utilization levels are 76.7%. The margin sacrifice problem is widespread and here to stay.

 

Productivity Step Change (PSC) is a global Management Consulting Group based in the US dedicated to maximizing Capacity Utilization, improving Return on Invested Capital (ROIC), and increasing productivity for its clients across industry. Our enterprise-level, data-led, cross-functional business analysis typically requires 4-6 calendar weeks and is designed to provide evidence of your opportunities for overall growth. Please contact us if you would like to schedule time for a discussion and presentation.

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