nullnull Author: Gisele GarrawayContributor: Steve BerezProfitabilityProduct LineMarch 1998Product Line ProfitabilityProduct Line ProfitabilityAgenda PLP overview
Applications
PLP steps
Client example
Challenges
Key takeawaysProduct Line ProfitabilityProduct Line ProfitabilityPLP overview
Applications
PLP steps
Client example
Challenges
Key takeawaysAgenda Product Line ProfitabilityProduct Line ProfitabilityPLP Description Product line profitability (PLP) is a diagnostic tool that helps us determine the “true” profitability of each product within a multi-product portfolio. Picture FramesOperating Margin2.3%5.3%7.0%10.0%Product Line ProfitabilityProduct Line ProfitabilityProfit Improvement Tools PLP analysis is one of the Bain diagnostic tools that can identify sources of profit improvement.0%5%10%15%20%0.10.20.5125ProfitabilityRelative Market ShareBain profit improvement tool kitPLP
BDP
RCP
VMRProfit Line Profitability Profit Line Profitability Why Bain Uses PLP Senior managers can use PLP analysis to make important decisions about product lines.For which products should we increase prices?
Where should we focus our cost reduction efforts?
Which product lines should we drop?
Which products should we focus R&D efforts on?
Where should we provide sales incentives?Product Line ProfitabilityProduct Line ProfitabilityTypical Accounting System Versus Bain PLP Unlike typical accounting systems, PLP involves driving below gross margin and allocating costs to get to an operating margin for each product line.Typical accounting systemBain PLPCost collection:By function (e.g. R&D, advertising)By product lineCost assigned to products:Cost of goods sold
direct labor
direct materialsAll costs, including all indirect costs
overhead
advertising
distributionKey product profitability measure:Gross margin (revenue - cost of goods sold)Operating marginCost allocation method:Accounting standardsActivity-based cost driversDisadvantage:Often does not reflect true commitment of resources and the returns for their useDifficult to capture all activities that drive costsProduct Line ProfitabilityProduct Line ProfitabilityDirect and Indirect Costs Traditional accounting systems often allocate only direct costs, not indirect costs, to products. And, in some cases, the direct costs are allocated inappropriately.Indirect costsDirect costsDefinitionTypical accounting
allocationPLP
allocationCosts generally incurred by the firm outside of the production process. These cannot easily be identified with or assigned to a particular productCosts incurred directly in the production of the product or service. These costs can easily be identified with a particular productNot allocated or allocated based on percent of salesAllocated based on actual cost driversTracked using accounting standards
Variances sometimes not tracked by productAll direct costs, including variances, are tracked by productProduct Line ProfitabilityProduct Line ProfitabilityInappropriate Direct Cost Allocation Some accounting systems allocate direct costs to products based on original expectations about production results. These assumptions cannot account for changes in raw materials use and labor time.Accounting standardActual for last quarterDifferenceRevenue per widget:$6.00$6.00Raw materials:$1.75$1.93Standard excludes loss
Increased loss due to change in supplier qualityProduction floor labor:0.30 hours x 8.00/hour = $2.400.45 hours x 8.00/hour = $3.60Standard excludes switch- over from main produce
Increased labor due to rework from lostGross margin:6.00 - (1.75 + 2.40) = 1.856.00 - (1.93 + 3.60) = 0.47Gross margin percent:31%8%Product Line ProfitabilityProduct Line ProfitabilityGross Margin Versus Operating Margin If accounting systems do not allocate all indirect costs to products, managers may misjudge products’ relative contribution to profits.Indirect costsPrice:$750$600$450Gross margin:40%33%44%Operating margin:29%20%23%On a gross margin basis, J-88s are the most profitable; however, T-54s are most profitable when all indirect costs are allocatedProduct Line ProfitabilityProduct Line ProfitabilityPotential for Mismanagement Failure to tie direct and indirect costs to individual product lines can cause firms to mismanage their businesses.Sales and marketingDistributionProduct developmentSpend advertising dollars on wrong products
Set up compensation and incentives to encourage sales of unprofitable productsPrioritize delivery schedules inappropriately
Establish wrong truck load ratiosFund unprofitable products
Kill profitable productsProduct Line ProfitabilityProduct Line ProfitabilityPaths to Low Profitability Multi-product businesses that do not understand their products’ true profitability become low profit firms.If gross margins are based on inappropriate accounting standards and indirect costs are not allocated appropriatelyHigh gross margin (potentially low net profit) products are given investment capitalLow gross margin (potentially high net profit) products are starved of investment capitalNew product line extensions are introducedAdditional complexity from growing number of SKUs increases direct costsProduct line extensions are ignored and profitable products’ growth slowsPoor profitability continues, driving high prices and poor positioning versus competitorsProduct Line ProfitabilityProduct Line ProfitabilityPLP overview
Applications
PLP steps
Client example
Challenges
Key takeawaysAgenda Product Line ProfitabilityProduct Line ProfitabilityApplications Bain has used PLP extensively. Some examples of our work include:Air transportationCommunicationsSituation:An air transportation company had various lines of business, but no activity-based accounting system. Management did not know which businesses, routes, or customers where profitableAfter suffering four consecutive years of negative net income, a voice processing service company was interested in understanding the economics and market positioning of their product linesResult:Bain identified unprofitable businesses, routes, and customers which in some cases were subsequently cut or pricing was altered to improve profitability. An analysis of costs indicated that profitability was much worse than thought, leading to a mandate for company-wide cost reduction and revenue enhancementBain assessed the profitability of three major product lines and identified savings of $20-$25MM on a cost base $110MMProduct Line ProfitabilityProduct Line ProfitabilityPLP overview
Applications
PLP steps
Client example
Challenges
Key takeawaysAgenda Product Line ProfitabilityProduct Line ProfitabilityPLP Steps PLP analysis involves six major steps.Understand client’s current P&Ls and cost collection systemsDetermine the major activities performedIdentify costs and cost drivers for each activityAllocate costs to each productAnalyze profitability by product or group of productsMake recommendationsKey Success FactorsIdentify all people and systems that report financial data
Understand linkages among and differences between the various sources of dataTie costs to operations, not accounting categories
Focus on the largest cost elementsQuantify drivers for each productPressure test assumptions with clients
Calculate over several years or periods to eliminate any seasonal or one-time effects
Make sure absolute profit of product lines can be reconciled with the total business’ profitsConsider strategic and operational alternativesMap the client's value chain from beginning to endProduct Line ProfitabilityProduct Line ProfitabilityKelly's Gourmet Jellies - Background PLP could be used to help Kelly’s Gourmet Jellies understand the profitability of its jar versus bucket business.Situation:Kelly’s Gourmet Jellies is a regional producer of high-quality, premium priced fruit jellies. Kelly’s has two major product lines:
8-oz jars to grocery stores for retail sale and
1 gallon buckets to universities, hotels, restaurants, and country clubsComplication:Indirect costs are not allocated to productsQuestion:Are 8-oz jars more profitable than gallon buckets?Product Line ProfitabilityProduct Line ProfitabilityPLP Steps Understand client’s current P&Ls and cost collection systemsDetermine the major activities performedIdentify costs and cost drivers for each activityAllocate costs to each productAnalyze profitability by product or group of productsMake recommendationsKey Success FactorsIdentify all people and systems that report financial data
Understand linkages among and differences between the various sources of dataProduct Line ProfitabilityProduct Line ProfitabilityKelly's - Sources of Cost Information An important first step in PLP analysis is understanding the client’s financial reporting system.Order databaseContentsReport TimingResponsibilityQuantities of jars ordered by customer
Quantities of buckets ordered by customer
Price per orderWeeklyMarketing/sales analystMonthly
manufacturing summaryOunce production by flavor
Employee time reportsMonthlyKitchen supervisorExpense report/vendor payments systemStorage inventory
Ingredient invoices
Utility paymentsMonthlyAccounting analystProduct Line ProfitabilityProduct Line ProfitabilityKelly's - Current Profit Reporting Kelly’s current accounting system shows that on a gross margin basis, 8-oz jars are more profitable than one gallon buckets. Overall, Kelly’s earns a 9.4% EBIT margin.Sales:$468,000$252,000Gross margin:$243,360$105,840Kelly’s Gourmet Jellies Profit and Loss
Jan-Dec 1996SalesCost of goods soldGross margin$720,000($370,800)$349,200Operating expenses($281,334)EBIT$67,866EBIT margin9.4%Product Line ProfitabilityProduct Line ProfitabilityKelly's - Operating Expenses Over $280K of operating expenses are not allocated to jars or buckets.Labor
Kitchen maintenance
Administrative
Warehouse
Delivery
Sales commission
Maintenance supplies - kitchen
Maintenance supplies - trucks
Utilities - kitchen
Utilities - warehouse
Depreciation
Kitchen equipment
Warehouse
Office equipment
Delivery equipment
Selling expenses
Other G&A
$5,955
$12,262
$6,590
$15,880
$56,880
$5,955
$1,985
$3,375
$12,706
$26,206
$7,624
$2,621
$11,117
$79,413
$31,765
$281,334Product Line ProfitabilityProduct Line ProfitabilityPLP Steps Understand client’s current P&Ls and cost collection systemsDetermine the major activities performedIdentify costs and cost drivers for each activityAllocate costs to each productAnalyze profitability by product or group of productsMake recommendationsKey Success FactorsMap the client's value chain from beginning to endProduct Line ProfitabilityProduct Line ProfitabilityKelly's Jellies - Process Flow Typically management interviews and plant tours help delineate the key activities that drive costs.Product Line ProfitabilityProduct Line ProfitabilityPLP Steps Understand client’s current P&Ls and cost collection systemsDetermine the major activities performedIdentify costs and cost drivers for each activityAllocate costs to each productAnalyze profitability by product or group of productsMake recommendationsKey Success FactorsTie costs to operations, not accounting categories
Focus on the largest cost elementsProduct Line ProfitabilityProduct Line Profitability After key activities are determined, all costs should be assigned to activities. Next, the cost driver will determine how costs should be allocated.ActivityCostsAllocation/cost driverRationalePreservingMaintenance labor
Maintenance supplies
Utilities - kitchen
Equipment depreciation$5,955
$5,955
$3,375
$26,206
$41,491OuncesBoth products use the same jelly, so ounces is the best proxy for relative use of equipment and facilitiesBoxes of jars and buckets can be stacked on top of each otherStoringWarehouse labor
Utilities - warehouse
Warehouse depreciation$6,590
$12,706
$7,624
$26,920Cubic feetKelly’s - Cost Drivers Product Line ProfitabilityProduct Line Profitability ActivityCostsAllocation/cost driverRationaleTotal operating expenses:$281,334Kelly’s - Cost Drivers Product Line ProfitabilityProduct Line ProfitabilityPLP Steps Understand client’s current P&Ls and cost collection systemsDetermine the major activities performedIdentify costs and cost drivers for each activityAllocate costs to each productAnalyze profitability by product or group of productsMake recommendationsKey Success FactorsQuantify drivers for each productProduct Line ProfitabilityProduct Line ProfitabilityKelly's - Cost Driver Collection Next, the key cost driver measures for each product must be collected to determine how to allocate costs among the products.Ounces produced and sold:8-oz jarsOne gallon bucketsTotalData source1,248,0001,075,2002,323,200VP, salesLabor hours required to deliver 1MM oz of jelly:24 hours10 hoursDelivery supervisor track schedulesAverage warehouse storage requirements:3,100 cubic feet1,900 cubic feet5,000 cubic feet Stock supervisorSales commissions:8.1% sales4% salesVP, salesSelling/promotional
expenses:
to retail (jars only)
to institutions (buckets only)
to public (jars and buckets)73,7951,638VP, sales3,980Product Line ProfitabilityProduct Line ProfitabilityKelly's - Cost Allocation (P.1)*Total costs for activity minus the costs allocated to jarsOnce cost driver measures are collected for each product, it is relatively straightforward to allocate costs.Sales:
COGS:
Gross margin:8-oz jarsOne gallon
buckets468,000
224,640
243,360252,000
146,160
105,840Preserving costs:[1,248MM oz/2,323MM oz] x 41,491=22,29041,491 - 22,290=19,201*Storing costs:[3,100 cu ft/5,000 cu ft] x 26,920=16,69026,920 - 16,690=10,230Product Line ProfitabilityProduct Line ProfitabilityKelly's - Cost Allocation (P.2) 8-oz jarsOne gallon
bucketsDelivery costs:[1,248MM x 24hrs/MM oz] /
[(1.248 x 24) + (1.0752 x 10)] x 28,982 = 21,32728,982 - 21,327=7,655Selling:
commission
promotions468,000 x 10%=46,800252,000 x 4%=10,08073,795 + [(1.248/2.323) x 3980] - 75,9331,638 + (3,980 - 2,138)=3,480 Corporate overhead:[1.248/2.323] x 47,648=25,59847,648 - 25,5978=22,050Total operating expenses:
EBIT208,63834,72272,69633,144Product Line ProfitabilityProduct Line ProfitabilityPLP Steps Understand client’s current P&Ls and cost collection systemsDetermine the major activities performedIdentify costs and cost drivers for each activityAllocate costs to each productAnalyze profitability by product or group of productsMake recommendationsKey Success FactorsPressure test assumptions with clients
Calculate over several years or periods to eliminate any seasonal or one-time effects
Make sure total absolute profit can be reconciled with client’s calculationsProduct Line ProfitabilityProduct Line ProfitabilityKelly's Jellies - PLP Results PLP results revealed that one gallon buckets are more profitable than jars.Current Accounting SystemPLPBuckets have:Lower warehousing costs
Lower promotional costs
Lower selling commissions
Lower labor costs in stocking and deliveryProduct Line ProfitabilityProduct Line ProfitabilityPLP Steps Understand client’s current P&Ls and cost collection systemsDetermine the major activities performedIdentify costs and cost drivers for each activityAllocate costs to each productAnalyze profitability by product or group of productsMake recommendationsKey Success FactorsConsider strategic and operational alternativesProduct Line ProfitabilityProduct Line ProfitabilityOptions for Underperforming Products If a product line is unprofitable or profitable but underperforming, there are five alternatives to consider.Can we reduce costs?Can we increase price?Can we increase volume?Should we keep product as a loss leader?Should we drop the product?What is our relative cost position?
Where is our relative disadvantage?How price sensitive are customers?
How will competitors respond?
Will a price increase encourage the entry of new competitors?Have we fully penetrated existing accounts?
Have we aggressively targeted new accounts?Is the product an effective loss leader?What will be the cost impact on other products?
How will competitors react?
How will customers react?Product Line ProfitabilityProduct Line ProfitabilityKelly’s - Recommendations PLP analysis can provide operational improvement tactics for Kelly’s Jellies.8-oz jarsGallon bucketsRe-negotiate promotion programs with key accounts
Lower sales commissions
Set higher product price
Re-route delivery schedulesIncrease sales commissions
Grow customer base - encourage new accountsProduct Line ProfitabilityProduct Line ProfitabilityAgenda PLP overview
Applications
PLP steps
Client example
Challenges
Key takeawaysProduct Line ProfitabilityProduct Line ProfitabilityVulcan* - Background*Disguised client exampleBain used PLP analysis to help a $300MM aluminum manufacturer understand where it made money and where it needed to focus its growth initiatives.Coated sheetFoilUses:RVs, campers, buses,vans, roofing, siding, garage doors, manufactured homesConsumer durables, disposable cookware and food containers, pharmaceutical packagingClient situation:Becoming more of a commodity business with tough pricing pressureConsidered more profitable than coated sheet product lineProduct Line ProfitabilityProduct Line ProfitabilityVulcan - SalesSource: 1991-1997 Income StatementsSales declined sharply from a 1994 high, although 1997 shows some signs of improvement.CAGR
(1991-94)CAGR
(1994-97)SalesVolume3.1%(9.8)%(17.5)%1.4%6.4%(10.9)%CAGR
(1991-94)CAGR
(1994-97)6.1%(8.3)%(32.3)%20.5%13.8%(11.0)%Product Line ProfitabilityProduct Line ProfitabilityVulcan - EBITSource: 1991-1997 Income StatementsEBIT was projected to increase in 1997, but to remain far below 1994-95 levels.CAGR
(1991-94)CAGR
(1994-97)EBIT/ sales:4.5%5.4%4.9%7.1%7.9%1.7%4.2%20.4%(24.7)%Product Line ProfitabilityProduct Line ProfitabilityVulcan - Process FlowThe Bain team visited a key plant and interviewed manufacturing employees to understand the key activities and process flow. Coated sheet and foil products went through a similar process up to the rolling phase.MeltingCastingCoilingFoil rollingShipCoatingShipIngotsRollingProduct Line ProfitabilityProduct Line ProfitabilityVulcan - Total Petersburg CostsSource: 1996 Income Statement; PLP ModelThe Bain team’s first step was to understand Vulcan’s total costs and their relative importance. The team studied a representative facility, Petersburg.Product Line ProfitabilityProduct Line ProfitabilityVulcan - PLP Methodology (P.1) Revenue:Actual revenue by order itemThe team went through each cost component and developed a methodology to allocate costs to foil and coated sheet products. Conversion:Adjust standard hours by part-number and method-number for each piece of equipment using November 1996 and March 1997 actual vs. standard hours comparison
capture actual operating hours for each piece of equipment using revised equipment time sheets
determine how accurately standards capture actual hours
understand drivers of difference between standard and actual
calculate adjustment factor to apply to full year 1996 by each piece of equipmentPaint:Actual paint cost by part-number and method-numberMetal:Use daily bookings data to assign actual primary metal price by customer sales order
Use actual price/lb for alloys and hardeners
Add melt and dross loss by alloy typeProduct Line ProfitabilityProduct Line ProfitabilityVulcan - PLP Methodology (P.2) Freight:Actual freight costs by order itemWorking capital:Actual accounts receivable by general product category (foil vs. coated sheet) and finished goods by part-number method-numberSelling:Allocated by actual salesperson’s time spent by marketG&A:Allocated as a percentage of sales dollarsProduct Line ProfitabilityProduct Line ProfitabilityVulcan - Petersburg Material CostsSource: Petersburg Metal ReceiptsThe Bain team began by examining the largest cost area, direct materials.Product Line ProfitabilityProduct Line ProfitabilityVulcan - Matching Data Since metal price was not captured in the shipments database, it had
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