Tuesday, September 13, 2011

That Customer or Product Line May Not Be Valuable

Intuitively, we may know that a certain customer just isn't worth the business they give you. You may think that about some product lines. You might have the gut feeling that even though this market segment has a low gross margin, it's worth it. There's a way to quantify these "feelings".

If you use Economic Value Added (EVA) analysis, you can figure out which parts of your business are worth their weight in gold and which are lead weights dragging down your business. EVA combines the profit and loss numbers with the balance sheet.

For the business as a whole, it's calculated by taking net operating profit after taxes (NOPAT) less a portion of the capital investment (weighted average cost of capital x (assets -liabilities)). For customers, product lines and market segments, a similar rough-cut calculation can be made. You'll find out who are the obvious winners, where the average lies and who's falling far behind and what it will take to get back into the pack.

For a customer, you can start with the gross margin. Subtract known additional (overhead) expenses relative to other customers by rating them in terms of their absorption of your technical staff or customer service staff time. Perhaps they make it difficult to collect money and your Accounts Receivable have to contact them constantly. Perhaps you have to have higher limits on liability insurance because of a contract with them. Reduce the net margin by the taxable rate for the corporation (or individual owners).

For the capital side, add up unique inventory items and their A/R balance. From these assets, you can subtract any known supplier payments outstanding. Usually the weighted average cost of capital is around 20%, so take 20% of this asset-liability difference and subtract it from the NOPAT calculated above.

All of these calculations are in dollars. You can then look at the relative dollars that each customer is adding to the value of your company. For the laggards, you'll be able to see if the improvement opportunity is in pricing, costs, the level of inventory, the terms you extend to them or some other factors that hold them back. You can decide if what your options are. You might also have to consider strategic options to improve that customer's EVA.

It helps you evaluate what needs to change to balance any accommodation for holding more inventory or extending longer payment terms for this customer. It helps you be creative with "Yes, if..." rather than cut-off any innovative thoughts with "No, because...". Sometimes you can find some really good value creating opportunities through this analysis.

We did this analysis for product lines in one company and found that some lines we inherited were dragging our enterprise value down. In order to get them in line with the other core portions of our business, we needed to: 1) raise prices (in one case by 500%); 2) reduce inventory and/or 3) cut overhead utilization of space, engineering and other support staff. The disappearance of these product lines was not going to cause any other business to disappear because they were not purchased by the prime group of customers. The only strategic benefit to keeping the product lines were for technology reasons. We could claim some experience with those kinds of products which might lead to some business in the core. Maybe.

Market segment analysis is not much different.

EVA is a simple analytic tool and powerful for improving your company's value. As the customers', product lines' and market segments' EVA increases, so does your company's EVA. As your company's EVA increases, so does your enterprise value.

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