Time to Act
Charlie Goodrich 
Hello and welcome to 2013,

I come across many business people who think their businesses, customers or products are making money when such is not the case.

In today's newsletter I explain what it means to make money and discuss four areas that are often worth probing to better understand if your business, customer or products really are making money.

Your comments are always welcome. Just click "reply" to send them to me.
Charlie Goodrich 

Founder and Principal

Goodrich & Associates
January 2013 Vol. 2 No. 1
In this issue...
Are You Really Sure You're Making Money?
Heard on the Street
About Us
Goodrich & Associates
[email protected]
Are You Really Sure You're Making Money?
I work a lot with distressed companies. I have to admit, many times I come across situations where I can't help but wonder: "What were the investors thinking?" There is no way they are or can make money.

Thirteen years ago, for example, I was working on a bankruptcy case. The company (now long gone) sold private label, FDA-blessed, bottled water - douche and enema. The products were made on the east coast in two operations in two plants, trucked to a nearby warehouse, then shipped as far west as San Diego to Wal-Mart.

It should have been obvious to anyone that there would be no profits left after all the material handling and transportation costs for such a low margin product. At best, profits would last only as long as the Wal-Mart buyer held his job.

In another, more current example, a good friend is the CFO of a well-known consumer brand. The company struggles more often than not, and at this point my friend is reporting to CEO number three. Here as well, the business model - one that can be described as buying from Exxon/Mobil and selling what is essentially a commodity to Wal-Mart, K-Mart and Sears - is not intuitively viable. Yes, they have EBITDA - but it's not the same as profit.

These are just two (of many) examples. So it is worth the time and effort to ask the question, "Am I really making money?"

But what does "Making money" mean?

Is it EBITDA (earnings before interest, taxes, depreciation and amortization)? Definitely not. EBITDA is a proxy for cash flow and often a poor one.

How about accounting profits? You know, that GAAP stuff that tries to match the timing of revenue with costs? Yes, this is closer. And while it's true that depreciation and amortization aren't real "economic" costs, they are a better proxy than no proxy at all for the decline in economic value of real and intangible property used in the business.

But the measure that should be used is profits after the cost of capital. Not just the cost of debt, but the cost of debt and equity. Since the cost of equity does not show up in profits, return on equity (or, for simplicity, return on capital of some form) is compared to the cost of capital.

Knowing where to look

As a practical matter, and in terms of understanding the profitability - or lack thereof - of a business, there are four areas that are targets for improvement.
  1. Not tracking direct (or relatively direct) measures, such as revenue and product costs, accurately.

    While direct product costs are often well understood, revenue deductions often are not. Trade credits, discounts, allowances and other sales reductions, are often lumped together and prorated on volume or some similarly non-granular measure.

    One bankruptcy client of mine, for example, never applied to the detailed records the substantial discounts taken by its big box customers. They never ascertained if the deductions were warranted and had no meaningful measure of profitability except at the total entity level.

    Ultimately, we found that gross margins in the SAP product and customer profitability system were four times greater than the gross margin reported in the financial statements. So the company was losing money by any measure and could not readily determine if any product or customer was profitable. Not surprisingly, sales and product management thought they had been doing a bang up job.
  1. Not understanding allocated costs.

    Everyone is familiar with overhead costs. Unfortunately, these are often treated as a given and not driven by product or customer mix. And while much has been done in the manufacturing world to tie indirect and overhead costs to products, the service world tends to lag behind. For example, are calls to a customer service center or help line dominated by a particular product, service or customer type?

    Another often neglected area is insurance costs for workers compensation, vehicle liability, medical benefits and so forth. Do these costs vary substantially by location, nature of the work, etc.? They usually do.

    Don't forget to measure invested capital accurately. Minimize allocations. This is particularly important when looking at product or customer profitability.
  1. Not measuring profits over a sufficiently long period of time.

    Depending on the industry and economic conditions, both costs and revenues can lag or spike unpredictably. Measuring over too short a timeframe can mask what's really happening.

    Many casualty losses, such as vehicle accidents, worker's compensation costs, product liability claims and so forth fall into this category. Often actuaries are used to estimate the true cost for a period to get a better measure. But there are many other expense items with similar patterns such as product warranty expense, returns, coupons and so forth.

    For cyclical industries, profits need to be evaluated over the life of the cycle. How many times have we heard someone say, "We'll make money when the industry picks up"? Maybe so. But if an industry cycle lasts five years and you are profitable for only two of those years, odds are high you are losing money in the long haul. Loan loss and bad debt expense is a similar example as credit cycles usually last much longer than a fiscal year.
  1. Disaggregating too much or incorrectly, or not looking at the true economic unit.

    Sometimes, the only way to get a true picture of profitability is to look at customers/profits in aggregate.

    When I was in the car rental business, for example, most vehicles needed to be rented at least twice a week to be profitable. That usually amounted to a given vehicle being rented once during the week to the business traveler and again on the weekend to the urban customer headed out of town for the weekend.

    The challenge was that the business customer wanted to rent at the airport, while the urban customer demanded a location downtown. Consequently, and in order to make profitability decisions, both locations had to be looked at on a combined basis along with supporting costs.

    A different example common to distribution businesses is that some products are sold with margins so low that the full cost, including the cost of capital, is never recovered. But sales of those products at those prices are needed to secure the customer and then sell less price-sensitive products at much higher margins.
So are you really making money? Take the time and look deeper.

Heard on the Street
Earlier this month, Carmen Reinhart and Kenneth Rogoff, authors of This Time Is Different, discussed a short (for academics) paper at a session of the American Economic Association meeting titled, "Reflections on the 100th Anniversary of the Federal Reserve."

Page two of their paper shows a frightening graph: The US Consumer price index restated in 1775 dollars. Prices remain relatively stable until World War II, when price levels start to rise and then explode around 1970. Plotted over the last 237 years, there is no recent discernible slow down in the rise of consumer price levels.

The paper discusses how inflation wasn't a problem when the Federal Reserve was created and how the role of the Fed has changed over time to respond to inflation and other monetary challenges. The authors argue that when judging looseness or tightness of monetary policy, besides the traditional measure of interest rates, pace and direction of credit growth should also be considered.

Click here to read the paper for yourself.

About Us
Goodrich & Associates is a management consulting firm. We specialize in helping our business clients solve urgent financial problems. Our Founder and Principal, Charlie Goodrich, holds an MBA in Finance from the University of Chicago and a Bachelor's Degree in Economics from the University of Virginia, and has over 30 years experience in this area.

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