Are You Managing Your “Lines” of Business?

A common problem in small to medium size LOBbusinesses is realizing that the business is really two or more lines of business. This condition is exacerbated by the tendency to view financial reports as a necessary evil in order to meet tax obligations and not as a tool to manage the business.

As a result, the revenue and associated expenses of multiple lines of business are commingled and they miss an important tool to manage the business effectively.

Case Study
A local company approached me to conduct a business assessment prior to leading them through a strategic planning process. The founder was confident that his company was well run and that the assessment and planning process would be a trivial exercise.

I asked to see a recent P/L (Profit/Loss) statement which reported that the company had annual sales in excess of $3.6M with a 5.5% profit.

Income $3,645,430
–        Cost of Goods $1,494,172
Gross Income $2,151,258
–        Expenses $   456,252
Operating Income $1,700,006
–        Admin $1,500,344
Profit $   199,662
% Profit 5.5%

 

Discussions with the management team quickly revealed that the company had at least three lines of business, two of which were very similar but served completely different markets and customers. The third line of business was a completely different product/service model, which was capital equipment intensive.

Due to the comingling of financial data it was difficult to see how each line of business contributed to the bottom line. Surprisingly, there were financial reports that did record the Operating Income produced by each line of business. The following table breaks out the Operating Income for each line of business.

LOB1 LOB2 LOB3 Total
Income $1,100,000 $1,650430 $ 895,000 $3,645,430
–        Cost of Goods $   297,000 $   660,172 $ 537,000 $1,494,172
Gross Income $   803,000 $   990,258 $   358,000 $2,151,258
–        Expenses $   110,000 $   198,052 $   143,200 $   456,252
Operating Income $   693,000 $   792,206 $   214,800 $1,700,006
% of Revenue 63% 48% 24% 47%
–        Admin       $1,500,344
Profit       $   199,662
% of Revenue       5.5%

 

The breakout clearly demonstrated the relative contribution to the overall profitability of the business. LOB1 (Line of Business) made the greatest contribution to profitability followed by LOB2. LOB3 also made a contribution but at a much smaller level. The main question to be answered was whether all three LOB’s were profitable. With some help from the management group, Admin expenses (general overhead) were allocated to each LOB. The following table is the result of that allocation.

LOB1 LOB2 LOB3 Total
Income $1,100,000 $1,650430 $   895,000 $3,645,430
–        Cost of Goods $   297,000 $   660,172 $   537,000 $1,494,172
Gross Income $   803,000 $   990,258 $   358,000 $2,151,258
–        Expenses $   110,000 $   198,052 $   143,200 $   456,252
Operating Income $   693,000 $   792,206 $   214,800 $1,700,006
% of Revenue 63% 48% 24% 47%
–        Admin $   452,725 $   679,265 $   368,354 $1,500,344
Profit $   240,275 $   112,941 $ (153,554) $   199,662
% of Revenue 22% 7% -17% 5.5%

 

The management group was quite surprised at the new breakdown where each LOB was measured in terms of profitability. Both LOB’s 1 and 2 were making a positive contribution to profit but LOB3 was consuming profit. This was double trouble when the amount of capitalization required for this line of business. A significant amount of capital had been invested in LOB3 and the Return On Investment (ROI) was negative. As a result the business was not recovering its investment.

This analysis quickly helped the management group focus on LOB3 to determine why it was not producing a profit. Immediately, three issues emerged that worked against the profitability of LOB3.

  1. Commercial/Industrial Mix: LOB3 served both commercial and industrial clients. The commercial customers were low margin business and were served because of a loyalty relationship to a customer base that helped start the business. Commercial clients represented about 70% of the available capacity. The remaining capacity available (30%) after serving the commercial clients was then available to serve the high margin industrial clients.
  2. Crew Loading: In addition to consuming too much of the equipment capacity of LOB3 with low margin business, it became apparent that the equipment staffing strategy was based upon the higher margin industrial business. The same crew (3 people) was assigned to the less labor demanding (only 2 people required) but lower margin commercial business.
  3. Load Factor: The capacity of the equipment was not managed well. A load factor (how many hours per day/per week) had not been established for the equipment. The load factor had to be met to provide a positive payback based upon acquisition and operating cost. Consequently, the equipment was assigned to available work but there was not a conscious effort or process to schedule enough business to keep the equipment loaded to a minimum level.

These three issues contributed to the unprofitable performance of LOB3. Surprisingly the management was in the process of justifying another piece of capital equipment for LOB3. The justification process was based upon emotion and not analysis. When presented with the data above, the management team realized that they had to make a major change in how they assigned LOB3 equipment to each market type – commercial or industrial.

Management quickly decided to drop a number of commercial accounts and load the equipment with industrial business 70% of the time and reduce the number of crew when working on commercial business. Once the existing equipment was loaded at or above the load factor under the new strategy they would then have favorable economics to justify the next piece of equipment to take on additional industrial business.

Conclusions
Despite the owner having a comfortable feeling that he was doing well to make 5.5% profit he had a serious cash drain on the business (by LOB3) that, if taken to zero, could almost double his profits. The additional granularity of financial data surfaced serious business issues with the use and allocation of capital intensive equipment.

The initial analysis broke the operation into three business units. Based upon the outcome and the impact of not managing LOB3 equipment properly there is justification to break LOB3 into two lines of business (LOB3.1 and LOB3.2). P/L’s for LOB3.1 (Commercial) and LOB3.2 (Industrial) would provide additional granularity of business data and put further scrutiny on each of these capital intensive lines of business.

Summary
As an outsider, I questioned the stratus quo and a critical discovery was made that could significantly change the way this business was managed and move it into a more profitable direction. The key point was confirming what I was being told (Trust and Verify). Verifying that the P/L confirmed the confidence of the owner that he had a solid business opened a number of opportunities to take the profitability of the business to a much higher level by managing his business as several businesses.

Align your products and services into distinct markets and manage them as unique profit centers and lines of business to get the best profitable results.

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