Wilting Profits

Question:

A landscape construction company has recently hired us to study the causes for its declining profitability. The company is 30 years old, and has increased revenues and profits annually for most of this period. In the last three years, however, profits have begun to decline.

Your task is to try to determine the cause, or causes, for this decline.

You’re not exactly sure what “landscape construction” means, so ask!

Candidate: I would like to try to understand what a landscape construction company actually does. Does it do the initial irrigation and earth works? Does it do landscape maintenance work?

Interviewer: Yes to both.

You’ve been told that profits are declining. Profits can decline for two reasons: either revenues are declining or costs are increasing. So, let’s test both possibilities.

Candidate: Have revenues been declining as well?

Interviewer: No. Revenues have increased by 5 percent every year for the last three years.

If it’s not a revenue issue, it must be a cost issue. Try to find out what exactly is costing too much. After identifying the costs, you might be able to suggest a way to reverse this trend.

Costs consist of fixed costs and variable costs. The former are “fixed” regardless of the level of revenues; and the latter vary with revenues.

Candidate: What about the company’s cost structure? Has there been an increase in fixed costs?

Interviewer:  Fixed costs have increased, but at a lower rate than the growth in revenues. Fixed costs as a percentage of revenues have actually declined.

Good, so it’s the variable costs that are the problem. Test this hypothesis. Three main variable costs are labor, materials and equipment.

Candidate: Then perhaps there has been an increase in variable costs. I would imagine that labor, materials and equipment are the major variable cost components. Has there been a significant change in wage rates? Are material prices higher? Or are is the company using more expensive equipment?

Interviewer:     I’m afraid none of these things have happened. In fact, the company recently renegotiated wages with the union. Hourly wage rates have declined from $15.35 to $15.00 as a result of the recent economic slowdown. In addition, material prices have also dropped marginally. And there have been no substantial changes in the equipment the company uses.

This seems like a tough case. Revenues are rising, but costs are not. However, while total revenues are rising, it’s still possible that the revenues per unit are not. In other word, it’s possible that margins are declining for some reason. You can probe the competitive environment to see if you can identify any reason why this might occur.

Candidate:  Well, we’ve been through all of the prospective internal effects that might negatively impact profitability. I would like to turn my attention to the external environment the company is operating in. I would like to test the hypothesis that increased competition is affecting the prices our client is able to charge in the market.

Have there been any new entrants into our client’s market? Or are existing competitors reducing prices?

Interviewer: I’m afraid neither of these is the case. There have been no new entrants into our client’s core market, and the established competitors are not reducing prices.

Looks like there’s no new competitive pressure on prices. Any decline in revenues per unit must be a decision made by the company. For instance, it’s possible that prices have been reduced intentionally to increase volumes. Or the decline in margins is the result of a change in product mix. Test both hypotheses.

Candidate: You referred to our client’s “core” market. What are the different markets, or customer segments, that the company does business in?

Interviewer: The company has identified three major customer segments. The so-called core segment is “recreational landscaping”, large new landscape construction projects, such as gardens, parks and golf courses. A second segment, “residential landscaping”, refers to new landscaping projects for private residences. A third segment, “landscaping maintenance”, is the ongoing maintenance required for existing properties. This is a new segment the company ventured into about four years ago.

Perhaps the product mix hypothesis is appropriate here. You need to pursue this idea further. If the company has been expanding its presence in a lower margin segment, it could account for the decline in profitability.

Candidate: What percentage of revenues do each of the three segments constitute?

Interviewer: Here is some information on revenue shares:

Screenshot_2017-07-02-00-25-41.png

This is enough for a hypothesis.

Candidate: My current hypothesis is that the maintenance segment has lower margins than the other two. The recent growth rate in this segment is reducing the overall profitability of the firm.

Interviewer:  That would be correct. So should the company continue to grow the maintenance segment?

You were right. So the question now is: Are current low margins worth it for a longer term gain in market share? An ROI-like metric would be an appropriate measure here.

Candidate: The answer to this question depends. Profitability is defined by net income as a percentage of revenues. Using this metric alone has certain pitfalls. It does not indicate return on investment, for instance. It is possible that while profitability is lower, the maintenance has a higher ROI, or higher return on assets. I also haven’t asked you whether profits are rising in the maintenance sector, which could indicate a positive trend.

Interviewer: Are there any other reasons, other than financial reasons, to continue to serve the maintenance market?

Yes, there are a number of reasons. Be creative.

Candidate: Yes, I can think of other reasons. First, it is possible that margins might improve with economies of scale, as the maintenance division grows. Maintenance services allow the company to nurture a constant relationship with its clients, and might enable it to win future construction contracts as well. Maintenance might also be a more stable business, which would allow the firm to weather economic downturns more easily.

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