Good business – Increase production, lower profits?
BY OREST PROTCH
In the children’s fable of Chicken Little we find our protagonist running around yelling that the sky is falling. In the fable of The Boy Who Cried Wolf we find our protagonist running around yelling that the evil wolf is on a rampage. In the fable of The Emperor Has No Clothes we finally get a protagonist who admits the obvious truth and at the right time that no one else was willing to state.
Three different parables but all three can be related to the manufacturing world and most likely to some people in your manufacturing organisation. Read that first paragraph again and see if you can find similarities to any of your colleagues and how they handle real life day to day manufacturing situations.
Our focus here is going to be on the story of Who is Willing to Challenge the Emperor.
The manufacturing world has little resemblance to what it was 30 years ago. Whereas it used to be common for a country to be fairly self- sufficient in terms of meeting its needs of supply and demand in its own little micro-world, that same country can now be heavily reliant on imports and exports to meet these same needs of internal supply and demand in what is now the industrial complex of the macro-world.
International trade agreements at an unprecedented scale have altered how a company has to look for raw material and even the labour pool to make the products of its livelihood. What used to be unofficial trade agreements between perhaps two countries in close proximity who shared a common border now encompasses politically dissimilar countries around the globe.
Our three fables at the beginning of this article can be correlated to any manufacturing company. They give us three scenarios.
Company executives state that unless the company increases production then it will be crushed by the evil competition who is doing just that (the sky is falling).
Company executives state that its very survival is already being crushed by the evil competition (the wolf eating the sheep).
A lone company executive states that all the above is completely false and based on incorrect analysis of the actual effects of the evil crushability factor (the emperor has no clothes).
Many companies are very similar to teenagers. Changing pheromones and hormones keep teenagers in a constant state of anxiousness and agitation and changing market conditions tend to do the same to manufacturers.
One common denominator of manufacturers since the dawn of the industrial age is to state that the solution to the perils of encroaching competition to its market base is to increase production. It is very easy to say that increased production will equate to increased profits and that is very difficult for anyone to dispute. Or is it? That is exactly what we are going to look at.
The decision to buy already existing facilities, adding expansion capital to currently owned ones, or simply moving and building in a new geographic location, is now often made by boardrooms that are responding to the stakeholders demands of better investment returns.
Too often the knowledgeable people that could, or would, challenge these sort of decisions are now absent from the decision-making meetings. Many companies have grown beyond basic employee input and it can be logistically difficult to collect the right information from the right people. Decisions to expand and/or move are often made without a detailed statistical analysis of what will happen to real overhead costs if you do increase production either locally or in another part of the country altogether.
Increasing production by capital expenditures can actually decrease positive cash flow when all the original profit projections indicate it would go up. How can this be? It is called tunnel vision.
It may be an interesting concept, that of checking future production goals against new overhead creation, but anticipated increased overhead may be simply ignored (back to the emperor fable) if it makes the investor charts and graphs look bad. And that is where many companies fall short.
With increased production capability there will be more income coming in. And this is a good thing. But there are two questions that need to be asked before you make capital expenditures and those are simply will there be enough new income to cover all the new expenditures that come with increasing production and does the company have the cash or credit reserves to cover the lag time of profits finally surpassing overhead costs. Lag time? We will come to that shortly.
The most important thing about asking these particular questions is that it forces you to look in the proper way at all the factors that go along with an increase in sales income. And if you miss a few, your net profits can and will actually fall with increasing production capacity. At head office meetings, after listing all of the reasons for increasing production, especially in visually appealing chart form, everyone will probably feel pumped, re- energized and ready to roll up their sleeves to have at it. No one, after all, wants to be a dissenting voice (again, with the fable).
So the decision will be made to expand production, move the facility or maybe both will happen. But hopefully there will be someone who remembers the basics of economics.
And the following points will be made, albeit maybe quietly by someone fearing the future unemployment line (the emperors’ axe):
ANNUAL FIXED COSTS WILL INCREASE, WHICH MEANS HIGHER OVERHEADS. THESE ARE CAUSED BY BUT NOT LIMITED TO:
• A bigger manufacturing building may be needed with associated increases in maintenance, municipal tax, insurance and utility costs.
• Higher costs will be generated in labour-hours due to the addition of high-tech maintenance needs of state- of-the-art equipment. More often than not highly paid specialists will need to be from other countries and will replace ordinary mechanics and electricians.
• Loss of foregone investment which is the loss of income if the capital had been invested elsewhere to collect interest or dividends.
ANNUAL VARIABLE COSTS WILL INCREASE. THESE ARE CAUSED BY BUT NOT LIMITED TO:
• Capital may need to be spent to increase the trucking fleet to carry products, both raw and finished. This will increase fleet maintenance costs.
• Exporting or importing duties may rise.
• Increased warehouse space for raw and finished products. More capital will be tied up with raw material and finished products.
• Transportation costs (fuel) will increase both for receiving raw material and for shipping the finished products (truck vs boat vs train).
• Warehouse space may be needed in other geographic locations if product storage is required before it gets to the customer if just-in-time delivery is not part of the supply contract.
We are going to look at an actual case study of a company from 35 years ago. But the past is not much different from the present. It was an automotive parts supply subcontractor whose manufacturing factory supplied components to one of the big three North American car giants but wanted to expand to get contracts with one or both of the other big car companies.
There is one final truth to any business decision. Hindsight is always 20/20. This company almost declared bankruptcy but it finally was able to negotiate more bank loans to get it over the financial difficulties it ran into.
You can add as many zeros as you want to each column but to make the associated graphs easy to read I have kept the numbers quite basic. True graphs would be of the logarithmic type where the superimposed vertical scales are different for each column represented but these can be quite daunting to interpret for those unfamiliar with them.
Keep in mind one thing as you go through what you may initially think is only a hypothetical situation that makes good copy. It actually happens most of the time when companies expand. How realistic are these numbers to today’s reality? Move the decimals around in the columns and what you are seeing can be in current time with a company trying to figure out what happened to the black ink in the ledger books.
So, we are going to start by assuming we are going to spend capital to increase yearly production on a consistent incremental basis because of various tax shelters and existing cash flow requirements and equipment depreciation rates. And it takes time to order new equipment and train new employees to operate it. Of course, this means that the annual total production cost will also go up with annual overhead. We also see an increase in the annual distribution cost of our products as the more we make the more it costs to ship what we produce.
The main problem with charts and spreadsheets is that it so easy to leave off critical information or to even look at the wrong parts of the data. In the numerical chart we see costs associated with increasing production. Presented in this form it is hard to see anything that could cause us grief in the future as production increases annually. The very people that may have seen the obvious may have been downsized, outsourced or simply no longer care what happens to the company.
Once information is in graph form we all find information easier to see, especially trends. One thing I would like to point out is that the combination of various rows in the chart to make each graph are not haphazardly chosen. So, let’s see what we have.
In the first graph we see that it will actually take a number of incremental production increases before gross income from sales is greater than the cost to produce the items and to ship them out to the customers. So even though the salespeople and the manufacturing people are doing their jobs, this can be a mentally taxing event for you if the bank statements keep coming back to you in the red. How would you react? Would you fire someone?
Notice what happens at the end of the projected time frame? Sales income starts to fall below production and distribution costs. Regardless of what you may think, basic economics states that this will happen with many company expansions.
In the second graph we see that there is a point in production where our profits will seem to surge, and that means celebrations will be in order. But then profits can flat-line leading you to assume someone or some group is slacking off. And yet the fixed costs are even declining with increased incremental production so if you react and cut staff at this point you have chased the wrong rabbit.
What would be your reaction at the end of the time period where profits drop like a stone if you do not appreciate the fact that the associated increased production costs are destroying your profit margins? Regardless of what you may think, basic economics states that this will happen with many company expansions. ➔
In the third graph we see that gross income from sales can lag behind incremental production increases until you overcome not only production costs but shipping costs as well. There may even come a time when the gross income from sales falls behind production and distribution costs. And yet your facility may be running flat out. Regardless of what you may think, basic economics states that this will happen with many company expansions.
In the fourth graph we have one that shows why it is so important to track a variety of business occurrences. Here we see that the increase of income from year to year does not come close to matching the increase in annual production cost increases resulting from increased capacity. Even though our cost to produce each unit comes down every year, it’s the yearly variable costs that can lead to business problems. Regardless of what you may think, basic economics states that this will happen with many company expansions.
As you sip your morning tea or coffee while reading this article, what you have read does not happen in the minority of cases when businesses increase production. It happens with the majority. Those variable costs that climb when you purchase new equipment or build a larger manufacturing plant can really take a bite out of your profits.
If a company does not understand why profits can decrease when making capital expenditures on new facilities then they can end up in a world or trouble.
That new and improved manufacturing centre of yours cost you capital to buy and set up, capital that could have been invested elsewhere. This is the foregone investment of the purchase. If you had put the money into stocks or bonds, then every second of the day you would have made income from the money. This is a cost that has to be added to overhead.
When I talk to people who are expanding their business about even this simple concept they have no idea what I am talking about. If I mention the need for calculating the increased intermediate warehouse space for raw material or finished products, their eyes glaze over
If you are committed to increasing your production capability by capital expenditures, go for it. Just do it with accurate forecasts, reasonable sales expectations and a very tight vice-like hold on your wallet when it comes to paying all those “hidden” expenditures that will pop up and take a bite. After all, you owe it to the people that may be displaced by bad decisions.
BIO - The author’s background extends from metallurgy, NDT, foreman including in a foundry, steel mill and saw mill, working in research and process labs, statistical process & quality control, water treatment and wastewater treatment, power engineer, pulp mill, instructing and training, writing manuals, oil & gas, writing articles and welding.