Your client is a paper bag manufacturing company. It manufactures a variety of paper bags in different sizes, thickness and specifications. Its products have a wide range of uses, from carrying milk in cartons to cement in 50-pound bags.
The company has been experiencing a declining return on equity recently, and is unable to determine the cause for the decline. The scope of your engagement is to identify what is driving this decline, and help resolve it.
This is an investigative case. The objective is to research what is driving the decline in ROE and present ways to resolve it. ROE can decrease either because of a decline in the numerator – “returns” – or because of an increase in the denominator – the “equity.” Let’s explore each reason in turn first.
Candidate: I’d like to dismiss the most obvious cause for a decline in ROE; has there been an increase in the company’s equity base recently?
Interviewer: No. In addition, the company has been paying out most of its net income in dividends, so the total equity has remained constant for the last few years.
So, there is a decline in “return” or net income. Net income can drop as a result of a decline in revenues, or an increase in costs.
Candidate: So, net income has been declining. Have revenues been declining as well?
Interviewer: Revenues have been increasing about 2 to 3 percent annually.
If revenues have been increasing, then costs must be rising for net income to decline. One way to categorize costs is to divide them into fixed costs and variable costs. The former don’t vary with revenues, while the latter do.
Candidate: Do we have any information on the fixed and variable costs? How have fixed costs changed?
Interviewer: Fixed costs as a percentage of revenues have remained constant.
Candidate: So, variable costs have been rising?
Interviewer: Yes, variable costs per unit.
You’ve narrowed the problem to variable costs. Two key variable costs in a manufacturing company are labor and materials, so let’s explore each of these first.
Candidate: I would imagine the key components of variable cost at this firm are material and labor. Have material prices increased? Or have labor rates?
Interviewer: Neither has changed.
OK, so this is getting a little complicated. If neither the materials nor the labor prices have changed, then either the quantities of materials or the cost of labor used for every unit of production have increased. This might happen due to waste or some inefficiency, or a decline in productivity. One clue might be a significant change of some sorts: in operations processes, an increase in the number of SKUs (stock keeping units) perhaps.
Candidate: I’d like to take a step back and talk about the company’s products. You mentioned an expansive product range?
Interviewer: Yes, the company manufactures over 10,000 SKUs.
Candidate: Has this always been the case? Has there been an increase in the number of SKUs recently?
Interviewer: Yes, in the last three years the number of SKUs has increased from 3,000 to 10,000.
An increase in SKUs for a manufacturing company can be the cause of a decline in productivity, stemming from changeover times of equipment. Let’s see if this increase in SKUs has been worth it for the company.
Candidate: Why has the company been doing this?
Interviewer: In order to target new market segments.
Candidate: Are all of these segments profitable? Or to ask this question differently, how many of these additional SKUs are profitable?
Interviewer: Very few of the new products are profitable, unfortunately. The company is perplexed because the actual cost of production is much higher than it had estimated, and this is why many products remain unprofitable.
Good, that’s what you expected. This change in the number of SKUs is probably driving the increase in costs as a result of higher changeover times and lower “throughput” – the volume of production that a factory can produce in a given period of time. It’s time to offer this as a hypothesis and test it.
Candidate: I would like to propose a hypothesis, but before I do, could you tell me if the company has bought additional plants and equipment to manufacture these new products?
Interviewer: No, it has been using capacity at its existing plant
Candidate: I think the tripled increase in the number of SKUs is increasing changeover time, which is the time taken for a particular piece of equipment to stop the production of one product, and start the production of another. The increased changeover time is reducing the overall capacity of the plant. Since fewer products are produced, the cost per product increases.
This hypothesis is supported by the fact that neither material prices nor labor rates have changed. The variable cost per unit, however, has changed, because the total number of units has declined.
Interviewer: Where would you look for symptoms of this increase in changeover time you suggest?
The symptoms would be found in the lower throughput, and therefore higher cost per unit of production. And the higher changeovers might also result in increased labor usage.
Candidate: The increased changeover time would manifest itself in a number of increased costs. First, labor cost as a proportion of total product cost might have increased, if the changeovers are manual. Second, the throughput – or the number of product unit equivalents that the plant can produce in a given period of time – has probably declined since the increase in SKUs. Third, it is quite probable that the margins of all products, including the old, profitable ones, have fallen because the introduction of the new products has reduced total throughput.
Interviewer: What do you recommend the company do?
Good. Now that we know the problem, prescribing a solution is relatively straightforward. The company must discontinue the unprofitable products that are burdening the system. Simultaneously, it needs to consider an operational audit to detect and eliminate bottlenecks and revive throughput.
Candidate: I would recommend that the company compute the profitability of each product, considering the changeover times involved in their manufacture. They should consider discontinuing the most unprofitable products. In addition, the company can assess process flows in the factory with a view toward minimizing changeover times and increasing throughput.
Interviewer: What do you mean by assessing process flows?
Candidate: A process flow analysis would chart the entire manufacturing process, especially focusing on matching the capacities of different equipment to ensure that there are no bottlenecks. The throughput of a factory is as high as the throughput of its slowest machine. For instance, if changeover times are especially high for one machine, the company might consider adding more of those machines.