Capital Markets

Profit Protectors

Seven things CFOs should think about as they move to save their company's net margins.
Don DurfeeJanuary 30, 2009

How quickly things change. Just a couple months ago, companies around Asia were flush with cash and sanguine about the future. Over long lunches CFOs would speak expansively about their evolving role from spreadsheet bean counter to CEO consigliere. They were the envy of their worried American and European peers.

Now it seems like a switch has flipped. As economic anxiety spreads across the region, finance chiefs find themselves cast once again in the familiar role of grim reaper, drafting restrictive new travel policies, going line by line through employee BlackBerry bills, and suggesting that perhaps at this year’s holiday party sparkling grape juice will be a fine substitute for champagne.

Expenses must be reined in, of course. But before you spend a half hour on the phone with the purchasing department deliberating the cost of staplers, consider some other ways of saving your margins. The seven items below have one thing in common: all will be easier for CFOs who have made progress in the strategic side of their jobs — those who are more consigliere than bean counter.

1. Go Where the Money Is

Broadly speaking, margin improvement efforts fall into two camps: crack the whip on costs or prod the sales team to sell harder. Think, too, about moving your company to more profitable parts of the business.

That’s what Ta Yang Group, a Hong Kong-based maker of silicone rubber products, has decided to do. Today the company mostly makes products on behalf of other, more famous brands, ranging from Apple Inc. to Nokia. It’s been a good business, but now the company’s margins are being squeezed.

“This product,” says CFO and executive director Kirk Yang, waving a floppy iPhone protective case in the air, “we sell for just 50 US cents. Do you know how much we paid for this one at the Wanchai Computer Center (a local shopping center)? About US$20. That’s 40 times our price.”

“They make US$19.50,” he says, referring to the company that puts its brand on the case and to the retailer. “We want some of that US$19.50.”

To do that, Ta Yang is starting to sell directly to retailers using its own brand, “Sipals,” earning a far higher margin in the process.

2. Get Buy-In for Your Cuts

Moving quickly to reduce costs is essential in a panic-filled climate such as this. But how you do it can make all the difference. “There’s an urgency to make cuts, and the temptation is not to have an inclusive process,” says David Michael, greater China chairman of the Boston Consulting Group. But make unilateral decisions without including the rest of the management team, and you may alienate your colleagues and destabilize the company.

A better way is to run a day-long offsite meeting, says Michael, who recently ran such a session for 25 client managers. He gave them a cost breakdown of their company, and indexed the numbers to 100 percent. He then laid down a mandate: reallocate costs so that 100 becomes 70. The managers got together in groups of five to debate it. “Putting people through the exercise lets people know that things need to be cut and gives them an appreciation of the tradeoffs,” he says.

3. Stop the Money Losers

Every company has unprofitable products and customers. The time has come to figure out which those are. When Kirk Yang joined Ta Yang earlier this year, the company had no cost accounting system. The CFO sent some accountants and engineers to the company’s factories to determine the true cost of the company’s products by examining factors such as number of units produced, defect rates, labor cost, material used, machine depreciation, and electricity consumed.

It turned out that the company was losing money on 10 percent of its 10,000 products. “Before, we were so profitable overall that there was no need to be efficient,” says Yang. “But now it’s getting tougher.” In addition to stopping production of those items, Ta Yang has made the facility managers responsible for gross margin, among other metrics — they must earn at least 15 to 20 percent margins. “Now that they have the data, if the sales people come back with low-margin business, they say no,” says Yang.

Similarly, companies should be figuring out the total cost to serve a customer. Simon Littlewood of Singapore-based consultancy Asia Now offers a rule of thumb. Work out the typical cost of a transaction for an item and compare it to the company’s total margin to get a rough sense of which transactions aren’t worth doing. Say, for example, that it costs $100 to produce an invoice and collect from the customer. If the average margin is 10 percent, then a transaction has to be worth at least $1,000 before the company will make any money on it (and much more before it meets the typical company’s required margin). “Do that simple math, and you’ll find tons of transactions that fall below that mark — every single one of them is unprofitable,” says Littlewood.

4. Become a Pricing Expert

If finance teams can help determine profitability by customer, product or channel, it’s not a stretch to imagine the function playing a big role in pricing. That’s not the case at most companies — pricing is typically a salesman’s guess of what the market will bear.

This was the case at the Indian division of Chemtex Global Engineers, a privately-owned chemical engineering business. A year ago, CFO Jimmy Spencer decided that, with margins declining and the cost environment becoming volatile, the company would be better off with finance in charge of pricing.

Like Yang, he found on closer inspection that prices often didn’t reflect the true cost — the company was either undercharging and losing money, or overcharging and losing the client. Part of the problem lay with incentives. “The incentive for the marketing team is only to sell the project,” he says. “They are not interested in whether you are going to make money.” The CFO, by contrast, is judged on net margins.

With finance’s involvement, Chemtex has been better able to factor in variables such as foreign exchange risk for cross-border projects and commodity price swings (engineering contracts often specify the price at which the firm will supply the necessary materials). Spencer can also make finer judgments about what business the company should, and shouldn’t, take. In some cases, for instance, it has made sense to actually take on a money-losing project if it means more fully utilizing the company’s main fixed cost — its employees.

5. Be Careful Where You Cut

The first item on the chopping block is — understandably enough — discretionary spending. Marketing budgets get chopped and sales bonuses shrink. There’s only one problem: such spending is often more closely linked to revenue creation than fixed costs. A business that tosses such investments overboard may help itself today, only to realize it has created trouble later on.

“Marketing is usually seen as discretionary spend, which it is,” says Giri Giridhar, CFO of Aditya Birla Retail, a two-year old unit of India’s Aditya Birla Group. “But if you don’t spend on the right promotions, you’ll do damage to your business.” The answer, he says, may be to reduce overall spending, but also carefully measure your marketing efforts to work out which offer the best value for money. In the case of his company’s grocery stores, that can mean trimming “above the line” spending (such as billboards or television advertisements) but maintaining “below the line” activities, such as handing out flyers in the neighborhood and running promotions for products that help draw customers into the store.

6. Create a Margin of Safety

During the last big crunch at the start of this decade, the world’s car makers took a painful hit: order volume dropped off 40 percent compared to what the companies had planned for. It was a difficult period for Indian car and tractor maker Mahindra & Mahindra. “We found that the margin of safety we used to enjoy — 20 to 25 percent — wasn’t enough during the downturn,” says Bharat Doshi, Mahindra’s group CFO.

Mahindra survived and Doshi made a decision: increase the company’s margin of safety — that is, the percentage by which sales volumes can fall but still allow the company to turn a profit — to 50 percent. Through steps such as a greater use of outsourcing, productivity improvements, and efforts to reduce sourcing and other costs, Doshi did just that. “That’s the buffer to absorb the shock, to help us get through the difficult times, during which the margin of safety shrinks. But the room created during good times helps keep the company profitable.”

David White, a China-based partner with consulting firm Oliver Wyman, recommends that CFOs consider protecting the firm with a shift toward variable cost structures. In fact, research conducted by his firm of the airline industry found that carriers that adopted a variable cost model — in this case by leasing aircraft rather than owning — outperformed their peers in terms of net income. “Even though it costs you more, you have that flexibility and in the long term you have greater value creation,” says White.

Granted, such decisions are easier to take before the economy stalls. Launch a big outsourcing project now and you are likely to pay dearly for the privilege.
7. Hold onto Today’s Savings

And that points to a lesson for CFOs during this crisis: If you come up with clever ways of keeping costs down today, try to maintain them once things improve. When the rupee was on its upward rise against the dollar in 2007, Mahindra & Mahindra scrambled to devise cost saving measures to soften the blow to its tractor exports. Its engineers came up with an idea — rather than buy four-wheel drive transmissions from a foreign supplier, they would develop a local version that would save over US$600 per unit. They did so in three months. The rupee has since gone the other way, of course, falling once more against the dollar. But Mahindra isn’t going back to buying the component. “Now that we have it, we aren’t giving it up,” says Doshi, adding that such steps contribute to a company’s margin of safety. “All those cost saving measures you put in during difficult times, you have to sustain in good times.”