Five Ways Middle Market Manufacturers Can Improve Performance and Profitability
By Todd Fagan, Assurance Partner
A large majority of manufacturers in the United States are considered small, whether a lower middle-market firm or a true small business. According to the U.S. Census Bureau, in 2015, there were 251,774 firms in the manufacturing sector, with roughly 74% of the firms having 20 or less employees and 98.5% of the firms having less than 500 employees.
Having worked with a significant number of manufacturing, consumer and industrial products and food processing clients over the years, particularly in the middle-market arena, I have identified five key areas that can be better managed and improved to increase business performance and profitability. Participants in the lower middle-market, and larger small businesses, typically reach a threshold where many of these issues, if not properly managed, can significantly reduce profitability and performance.
Additionally, when revenue is increasing, management is less cost sensitive. Further when growth occurs at a fast rate over a short period, inefficiencies can develop and margins can sometimes drop. Following these guidelines can help middle market manufacturers capture more profits and continue sustainable growth.
1. Capturing and Tracking All Inventory Costs at the Point of Conversion
Inventory in a manufacturing and food processing environment is more than just material costs, it also consists of labor, overhead costs, and storage in many cases. Accurately and effectively capturing all these costs and assigning them to the proper job or product is imperative if an organization wants to accurately account for their inventory assets and cost of goods sold. Properly collecting these costs requires effective processes and a system of internal controls. Correcting this deficiency will improve reporting and lead to better pricing decisions and reduce significant inventory adjustments that affect your cost of goods sold at the end of the fiscal year.
For example, not too long ago I worked with a lighting manufacturer who built specialty, custom lighting products for commercial applications. They lacked formally defined processes for requisitioning parts inventory when building and assembling their finished lighting products. Additionally, they didn’t have a system to effectively capture the usage of the inventoried parts, so much of the usage didn’t make it to the specific job within the accounting system. This allowed for inaccurate part inventory amounts and values that resulted in significant cost of goods sold adjustments at year end. Further, the assembly labor costs were not accurately tracked to the job when the work was being performed. Effectively, jobs that required more labor than was estimated at the time of the Sales Order or quote, were not being tracked and assigned on a direct cost basis.
This may seem like an exaggerated case, but it highlights the importance for structuring and designing a system that captures and tracks labor and inventory usage at the point of conversion. Deficiencies in this area lead to poor pricing decisions, inaccurate inventory and period end adjustments that will routinely reduce financial statement performance.
2. Rework and Warranty Claims
This is an area that is normally overlooked when costs are not significant. However, rework and warranty claims can easily become significant in a short period of time if the manufacturing process does not have a well-managed and effective Quality Control process that identifies and remediates deficiencies with continuous feedback.
I worked with a technology accessory manufacturer that used a contract manufacturer in Asia to manufacturer their product. Product quality became an issue for the main customer, which was a well-known accessory brand and a recall was eventually required. This significantly impacted the company and their financial position to a point of near catastrophe.
Another example involved an apparel company. They didn’t have a defined process to account for returned and replaced garments Although this was not a major crisis, it did impact their inventory tracking and their financial performance. If management invests early in the product development and quality monitoring cycle, needless costs can be avoided and customer happiness will be increased. Two things all manufacturers can appreciate.
3. Inefficient and Excessive Use of Energy
Energy usage and consumption can be a huge cost driver for many manufacturers. In fact, manufacturers consume more than 30 percent of the nation’s energy. U.S. industrial users consumed 26 quadrillion btu of energy in 2018 and that amount is expected to grow at 31% to 34 quadrillion btu by 2050.
For smaller, mid-market companies, energy management does not always get the attention it deserves. But management programs and improvements can produce real cost savings that can really improve profitability. Lighting, heating and cooling, proper insulation, machine idling, and leaky boiler pipes are just a few examples that can seriously contribute to energy waste, which impacts the bottom line of many businesses. Heating and cooling large facilities alone are a significant cost.
For example, converting from a 34 watt fluorescent tube to an equivalent 16 watt LED tube would save approximately $26 per bulb if operated 24/7 for one year. Take a space that has 200 bulbs and you have an annual savings of $2,600 is operated 12 hours a day or $5,200 if operated 24 hours a day. Grants in some states, such as Maryland are available to manufacturers to improve energy utilization. This is a win-win for manufacturers and the state, as most buyers avoid improvements due to the immediate cost outlay. Consider an energy audit and put a program in place to improve the use of energy consumption throughout your plant, warehouse or office facility.
4. Material Waste and Theft
It is still surprising to me when I do a walkthrough of a plant and a production line and see significant waste. Waste minimization is a mindset and needs a system of controls to reduce it and ultimately prevent it. In the food processing industry, this can be compounded as once material hits the floor, it cannot be reprocessed/reworked for human consumption. I take the view that anything less than 100% of the raw material converted to the finished product is less than optimal and a loss to the organization.
For example, I once visited a seafood processing plant that produced fish nuggets and patties for commercial and institutional consumption. The fish came into the plant in a partially processed frozen block form (already scaled and deboned). These fish blocks needed to be portioned and breaded. In processing the roughly 20 pound blocks into filets, strips or nuggets, the blocks were cut with a food grade band saw. This process produced a significant amount of “fish dust” or scrap product, just a cutting a piece of wood would produces saw dust. The amount of “fish dust” was at times in excess of 8% of the weight of the fish block. This was astounding as the scrap that was produced had limited usage and value per pound. What was even more astounding was that one of the owners didn’t know how much scrap was being produced from each block.
In my mind, this was a lean Six Sigma project as the amount of waste was unacceptable and very costly. The bottom line is: know your yields and invest in limiting waste and safeguarding your raw material now to save money over the months and years ahead.
5. Ineffective Financial Reporting
A financial reporting function should provide your organization with accurate, timely and usable information for decision making, in addition to fulfilling compliance requirements. Information that is poorly collected and processed is not reliable, no matter how experienced your management team. Many small organizations don’t fully understand and quantify missed opportunity cost. Obviously, any new software implementation is a cash outlay, but the future savings should be quantified and measured though a net present value calculation.
The old adage “time is money” is certainly true here. An effective financial reporting system, which includes a properly implemented software product, trained users and a system of controls can provide significant value. Not only can your historical performance be measured, your organization can track and improve margins and yields when the manufacturing data is produced in a timely fashion and accurately collected. Not having an effective financial reporting function can be a road block or hurdle for bank and investor financing. If the organization does not have a perpetual inventory system, doesn’t know its gross margin by product/sku, or doesn’t have the ability to allocate and separate costs per products effectively, then improvement and remediation is needed.
If your net present value is positive, then spend the time and invest the money today to properly implement a financial reporting system that addresses your specific needs and can collect information at all the important control points. Don’t let GIGO (garbage in, garbage out) be your financial reporting function’s motto!
Addressing one or more of these areas can have a dramatic impact on your manufacturing firm’s profitability. In many cases, your organization can begin with a relatively simple assessment by an outside professional or internal resource. However, make sure to get the right professional with expertise in that area to assist your organization so you can make the most of the effort and maximize your cost savings or value add.