TURNING AROUND a THREATENED BUSINESS
Company ABC corporation has 140 MioEUR sales, the majority coming from
it's major product line P where they sell 10 Mio # p.a. at 10.-EUR/#.
GrossEarning for product P is 30%, material and purchases account for
40% of sales. Installed line capacity for product line P is loaded to 75%
of max capacity. It is an automatic assembly line requiring no direct
labour - just operators to maintain the equipments.
The gross earnings (=GE) of 30% according to the StdCOS modell are by chance
identical to GE=30% had ABC Inc. applied activity based costing.
Overall ABC Corp is making a loss of 3.6 MioEUR p.a. The GenMgr has asked
his first line to come up with ideas to turn around the business or
they will have to close the plant.
The Operations Mgr committed his organisation to deliver 8% cost reductions
instead of the budgeted 4%. This does not bring them out of the sink
8% of (100%-30%-40%)=30% = 2.4 percent points of sales cost reduction
2.4% of 140 MioEUR is 3.36 MioEUR cost reductions. This is not enough
as these reductions are bound to not materialize in the current fiscal
The sales director turns up with a business opportunity to sell 2 Mio#
p.a. more of product P (which is well within the available capacity).
The downside is that the price would be 40% below the going price - in
other words 6.- EUR/#. As it is a segmented market there is no fear that
the price in the main market will be effected.
What should ABC Inc do ?
Decline the additional business !
Current rules forbid to accept a business at negative margin (30%
GE - 40% price decrease = -10% GE). Common business sense clearly says
that we have to decline that business as it will drive us deeper into
Consequently ABC Corp will go bankrupt, all jobs will be terminated and
the plant will be closed.
Apply activity based costing and ....... (here I expect the ABC experts
to chime in and continue to develop a sucessfull solution).
Apply common sense rather than standard costing rules (or probably
activity based costing - I'm waiting for answers from ABC experts).
Common sense tells me to accept the business even against what current
rules say. It's a matter of "last chance"- take it or leave it. Let's
If we take the business we will have additional sales of 12 MioEUR.
Material cost continues to be at 4.-EUR/#. So this additional business
consumes 8 MioEUR but gives us an additional throughput of 4 MioEUR.
What about the rest of the operational cost ? We have enough capacity
in the production line to serve the additional business. If we keep it
running the only additional cost will be energy and consumables such as
oil, compressed air and some such type of cost. Usually this does not
account for much and so we assume that 0.1 MioEUR are sufficient to
cover all our additional operating expenses.
Now here is what we get :
12.- MioEUR sales
-8.- MioEUR material and purchases
-0.1 MioEUR additional operating expenses
+ 3.9 MioEUR additional profit (bottom line!)
There is no question ! We have to take the business and ABC Inc. will
be out of the red immediately.
Such is the power of inertia in our management world that the tough
guy's prefer to close plants and cut jobs rather than use common sense
and develop new business.
BTW : this method of preparation for decision making is not exactly new.
In German speaking countries it is known as "Deckungsbeitragsrechnung". In
the English speaking world it is called "Throughput Accounting".