If you could increase your revenue by 1% or lower your cost of goods sold by 1% which would you do? Would you even bother to spend the time and resources to only achieve a 1% improvement?
One of the biggest challenges to performance improvement, especially in a healthy company, is trying to get a handle on how improvements will impact the overall business. To further complicate matters, resources are limited so trade-off decisions must be made on where to focus improvement activities. For example, should we have engineering work on cost reductions and manufacturing improvements OR should we have them work on new products that will help grow the top line? What about lowering our sales and general administrative costs? Should we focus our limited attention there or would we be better off trying to reduce our production overhead?
Sadly, current “pain points” may be the items that get attention as opposed to other areas that may have better returns. But the question still remains as to how to determine what areas will have the biggest impact.
To help answer this question, we have developed a simple model to understand where to focus first. It is based upon what individual improvements in various portions of the business will have on the overall value of the business. As a simple first pass, 1% improvements in key areas are evaluated for their impact. The impact of even 1% improvement can be dramatic.
Consider for example, a small manufacturing company with $1M in sales, good product margins, and manageable fixed costs as shown in Figure 1. If nothing changes in the company’s performance year over year (a very simplistic assumption to be sure!), the company’s present value is $1M (calculated by discounted cash flows with a 10% cost of capital hurdle).
Figure 1.0 Small Manufacturing Company Valuation Example
If 1% improvements are achieved in six areas (price, unit volume, cost of goods sold, production overheads, S&GA, and capital expenditure), the overall value of the company increases not by 1%, but by 21%! The details of which areas contribute the most are shown in the bridge chart in Figure 2.
Figure 2.0 Impact of 1% Improvement in Company Value
The bridge chart has now begun to answer the question of not only the overall impact of performance improvement, but those areas that have the biggest impact. For example, a 1% price improvement would increase the value of this company by 9%, whereas a 1% reduction in capital spending would have less than 0.1% impact. Clearly, focusing on pricing should be a priority over reducing capital expenditures. And note that sometimes performance improvement initiatives are hung with lofty goals of double-digit improvement. Note that even a 0.5%-1.0% increase in price is well worth the effort.
Other areas begin to emerge as candidates for focus. In this example, there is more to be gained by focusing on improving the direct cost of goods sold (a 5.5% increase to company value) than by increasing unit volume (a 3.7% increase to company value). So, all things being equal, we should assign engineering to work on cost reductions before working on product development that would result in more unit sales.
Of course, the areas of focus will vary depending upon the specifics of the company. But the improvement in company value by small improvements in individual areas can still be dramatic. A simple sampling of publicly available data of small to mid-cap firms using this methodology shows that 1% improvements can increase a company’s value anywhere from 15-40%.
With this in mind, it now seems apparent more than ever that striving for even small improvements in the right areas are well worth the effort. So what are you waiting for?