Don't Let Unproductive SKUs Sink Your Boat

By Guy Schneggenburger

In good times and in bad, businesses look to increase profits. However, it is during troubled times when businesses focus on aggressive cost reductions. There is no doubt that taking actions such as making across-the-boardcuts or playing hardball in negotiations with suppliers will provide direct, near-term savings. One of the fundamentals to The KGI System™ is that not all cost cutting efforts have equal value, and there is a need to look long-term and evaluate both sides of the profit equation - revenues and expenses.

While reducing expenses is often more immediate in impacting the bottom-line, changing focus to identify unprofitable products and services often goes further to increase the health of a business. Time and again, the most constructive action a business can take to increase profits is to stop doing something that is unproductive.

Businesses must determine which products drive profitability versus those that drain it. Product or Stock-Keeping Unit (“SKU”) rationalization enables a business to do so - identifying and keeping the profits earned with “Value-Add” SKUs and also identifying and reducing the impact of “Value-Cost” SKUs.

The graph below demonstrates the concept. Value-Add SKUs are the individual products and services that have a positive net margin for the business; Value-Cost SKUs are those that have a negative net margin when all associated expenses are tallied. The Available Profit is the amount of profit provided by the contributions of the Value-Add SKUs. It is the maximum profit available to the business with the current product line. The Actual Profit is the Available Profit minus the net loss of the Value-Cost SKUs, also referred to as Lost Profit. The process of SKU Rationalization identifies and quantifies the Value-Cost SKUs and the Lost Profit to enable a business to realize its Available Profit.

While this may seem to be a simple concept, a significant barrier stands in the way of successfully identifying the elements so neatly displayed on the concept graph - the business must have financial reporting that correctly allocates costs to SKUs. This type of financial reporting is in contrast to typical GAAP accounting. Sometimes called “Value-Stream” accounting, it tracks the flow of materials and information required to bring a product or service to a consumer. In doing so, each SKU or family of SKUs is assigned with its share of expenses from both the Cost of Goods and the SG&A sides of the business (i.e., machines, facilities, labor, investment, inventory, and management). Several issues contribute to the aforementioned barrier of accurately and systematically tracking this information:

Lack of expertise
Incorrect allocation methods
Incomplete or missing data
Poorly designed or implemented IT support
Difficulty in quantifying departmental activity
Complexity of analysis
Time required to perform the analysis

KGI has the experience and the skills to help businesses recapture Lost Profits and make strides toward achieving the maximum Available Profit. We have a strong track record of assisting businesses with efficiently implementing a SKU Rationalization process to increase profitability without incurring downtime, excessive costs, or unnecessary reorganization. Here are some recent examples:

Problem: A $120M food processing company ran three shifts, five days per week, and maintained a highly specialized delivery network to bring products to their customers. Years of increasing losses despite across-the-board cuts and price increases caused the company to seek assistance.

Solution: KGI discovered that a particular product line was driving the need for a three-shift operation, and this line also cost the company an additional $2.5M in unique transportation expenses. Once identified, the company decided to limit production on this product family to the amount that could be made in one shift. Given that all other products could be processed in one shift, this was the lowest common denominator.

Result: The company increased net income by $9M from the eliminated expenses associated with the Value-Cost SKUs despite a $5M decline in sales.
Problem: A manufacturer of medical products had annual sales of $195M with a product line of 380 different varieties of a product. The company suspected that it had too much product variety, but did not know how to quantify each variety's effect on the financial results. Afraid of sacrificing top-line sales by offering fewer products, the company did not act upon their suspicions without the getting expert advice.

Solution: KGI demonstrated how to allocate costs to specific varieties in order to determine the profitability of each. After a period of product reengineering, the company simplified their product line from 380 to 75of the highest Value-Added SKUs. Taking this action allowed the company to i) decrease raw material expense from higher volume and fewer materials, ii) decrease manufacturing expense from simplified scheduling, and iii) decrease distribution expenses from increasing interchangeability of customer orders.

Result: The company's net income improved from $1M annually to over $15M annually while maintaining the same sales level.
Problem: A transportation manufacturer had 34 varieties of a product that produced $150M in annual revenue. The company understood that some varieties required more parts and materials than others and questioned whether all products generated relatively similar revenue streams and sought help with this issue.

Solution: KGI determined that the products could be divided into two different groups of equal size based on their number of parts. Interestingly, the two groups were very unequal in regards to their total sales: one group required fewer parts and provided 80% of the company’s sales; the other group required more parts and only provided 20% of sales. Once this was known, KGI conducted a market analysis to determine if the company would be materially harmed from discontinuing the product varieties that provided only 20% of sales. The study found that customers were indifferent to the varieties in the 20% group, and if these lines were not available, customers would willingly substitute such with varieties in the 80% group. On the basis of this information, the company discontinued the product group that was not only generating the lesser 20% portion of sales, but was also fueling higher inventory levels by requiring more parts.

Result: By forgoing only $3M in revenue (2% of the total) due to lost sales, the company gained $9M in working capital from reduced inventory investment and increased net profit by $5.5M as a result of simplified assembly, supply, and engineering functions.
Problem: A multi-billion dollar distributor of medical products had a company policy of providing its customers with a fill rate of greater than 98% on all products. The company believed in its concept and made significant capital investments in systems and safety stock to support it. Nevertheless, the company was generally unsuccessful in fulfilling its commitment and was incurring sizable expenses in the process. The company asked for a review of its policy in relation to achieving company goals while meeting customers' needs.

Solution: KGI devised a strategy that enabled the company to achieve both a high fill rate and lower total costs. The key to the strategy was to work with the company’s customers in developing a “Product Significance” list so that the company could maintain a local supply of “must have” products while aggregating demand for lesser used items on a regional and national level. With the appropriate SKU rationalization system, the company could then track specific products and align such with the Product Significance list in order to create optimal inventory levels.

Result: The company is now able to consistently fill orders at the policy level without draining profits through unnecessarily expensive systems and safety stock.

KGI offers solutions and obtains results. We can help your business achieve its optimal position on the SKU-to-Profit graph. We specialize in:

Distinguishing the Value-Add SKUs from the Value-Cost SKUs
Identifying non-value-added activities
Discovering planning and control problems
Correcting cost allocation models
Understanding capital investment requirements
Closing the gap between operations concept and operations reality

By taking a proactive stance on unproductive SKUs, businesses can significantly increase their profitability and cash flow.

Whether a Company is struggling financially or on the cusp of breakthrough growth, KGI can help. Our seasoned experts work alongside management to solve complex cash flow issues, operational challenges and other business crises. If liquidity or sale is needed, KGI provides a powerful combination of services and expertise to achieve outcomes that cannot be duplicated by other standalone consulting firms.