How Boards Can Destroy Profitability

I’ve taught operations management for decades and sometimes factors that appear obvious to me are often not obvious to managers with no operations experience.  One of these factors is the concept of “hollowing out.”  I see the tendency toward hollowing out taking place in economies and companies, both service and manufacturing, quite often.  Its hallmarks are the desire, by managers working with the financials and predominantly the bottom line, to find new efficiencies by eliminating unprofitable activities, services and products.  I’m not saying there is anything wrong with doing that.  On the contrary, I would hope that managers would always be driving out inefficiencies and optimizing profit.  However, there is a major hazard to doing this that must be kept in mind as these decisions are made; the concept of hollowing out.

The definition of hollowing out is the process by which a company, by outsourcing, selling or eliminating products or services or activities, reduces the profitability of the remaining products, services or activities because that eliminated product was carrying and providing support for synergies of sales or covering overhead and/or capital costs.  The consequence of the elimination can create a loss of sales synergies, greater overhead for the remaining products/services that make yet another product/service become unprofitable and thereby, using the same criteria, ripe for outsourcing, sale or elimination.  

This chain of actions thus creates the situation where the financial managers, through the best of intentions, create a company that gradually has fewer products, services or activities as they take them out of the company product/service mix and increases the costs allocated to each remaining product/service.  In other words, the managers can be gradually selling off their company and eventually making it completely unprofitable and a “hollow shell” which no longer provides any products or services at all.  

The problem with hollowing out is that managers must be familiar with the operations and sales of their products/services to know if there is interdependency.  Failing that, they must be experienced enough to seek out advice of the operations group or sales group to find out where these synergies may lie prior to making cost cutting decisions.  

I’m sure you been in these discussions.  “We need to cut costs now.  We are losing profitability and we are under a lot of pressure to improve the bottom line.  This is a list of products/services that are currently not providing profit. We need to cut enough of these to improve profit margin by 5% right now.”   It looks like a simple choice.  Cut product/service A,B,C and profit will go up by the required 5%.  There will be some resulting layoffs or reduction in inventory or other expected savings.   On paper it looks like a great choice.  However, let’s examine a few of these types of decisions and the real life results.  Here are two recent real-life very simple examples:

Service to Non-profits

A company, well known in the non-profit world provides support for board and constituent communication.  They bundled their service with a payment collection service and the non-profit would pay for both services together. Recently this company unbundled this payment service and required that customers use their own payment service or pay a fee to continue using the old payment service.  This unbundling for some customers created a quandary. The bank they used for the payment collection service is their bank for all other services such as investments and collections and dispersion of funds.  The service company had not anticipated this inter-relation to their client’s banking and lost the payment collection service completely due to the fact that the bank, in response to this demand, offered a slight discount to their payment collection service because the non-profit client was a very good customer with millions in activity.  

Non-profit activities

A large non-profit was losing a significant employee that was managing a service with 10,000 email connections. This service had been a small concern 5 years ago but from the activities of this employee had grown considerably. This service was not part of the main goals of the non-profit, nor did it bring in large donations.  In fact, the donor support was declining and it cost about 50K more than had been provided through fundraising.  It appeared to be a good option to eliminate this service as this employee was leaving, reducing costs by about 200K for the non-profit. However, the non-profit did have a lobbying effort that was a large part of their activities and the service in question provided not only name recognition but also connection to a large population that was supportive of the lobbying efforts.  

This had never been identified as an important piece of the lobbying effort but one question: “Does this service provide any benefit to other areas that might be more important than just the cost savings we are considering?”  opened up the discussion of synergy and the board decided that keeping this service was far more important than the cost.  Further the board determined that a focus for fundraising would be helpful to cover the costs and provide opportunities to expand this service rather than eliminating it.  

The Hollowing out process

What basically happens is that an organization identifies a list of products or services it provides and looks at the financials of each individually as though they are completely disconnected in any way.  In other words, eliminating one of these services or products has no impact on the others.  

However, there can be a domino effect because in fact they are all related by virtue of being produced in the same facilities, by the same people, and using the same overhead support.  Thus the elimination of a single unprofitable product redistributes the costs to the remaining products.  This can have the effect of making yet another product unprofitable and causing the same action yet again for a second product….creating a third unprofitable product as the costs are shifted etc.  Why? Because eliminating a product does not normally completely eliminate all the costs that are currently associated with that product since costs are shared at a location.  

This elimination can be in the form of discontinuance of the product or service completely, sale or spinoff of the product or contract manufacturing of the product at a cheaper facility.  All these decisions can create the beginning of this domino effect if the analysis is only from a financial perspective. The same effect can happen for whole divisions of a company as well.  

The income statement in Figure 1 below illustrates simple example of two products/services for a company.  Clearly Product/Service 2 does not currently make money for the company.  In a financial analysis it seems to make sense to discontinue product/service 2.   Let’s examine this decision from the perspective of operations by each cost of goods sold category.  

Wages

The employees that produce or support A are also supporting B.  Nearly half of the wages paid are covered by the revenue from B.  Currently employees only work on A and B.  Eliminating B means that all wages for B will now be loaded onto A.  We believe that 25% of the employees can be laid off if we discontinue B.  This results in a savings of wages of about $23.75.

Overhead

The overhead costs will not decline with the elimination of B.  

Capital Use

The same equipment is used for both products with the exception of one extra machine for B.  The sale of this machine will result in a savings of $5 in capital use.  The remaining costs will be loaded onto A.  

Figure 1: Income Statement
DescriptionA Product/Service 1B Product/Service 2Total
Revenue10080180
CGS
      wages504595
      overhead201535
      capital use152540
       
Total expenses8585170
Profit15(5)10

 

Figure 2: Income Statement illustrates the resulting financial changes due to the discontinuation of product B.  
DescriptionA Product/Service Total
Revenue100100
CGS
  Wages80.7580.75
  Overhead3535
  Capital Use3535
Total Expenses150.75150.75
Profit(50.75)(50.75)

 

As a result of the discontinuation of B, the company makes only $100 revenue rather than $180 and loses $50.75 rather than makes a profit of $10.  

In addition, there are other synergies for products than just the operations area.  Marketing and sales can find a lot of synergy between products that can be hidden from financial reviews.  There are instances where the clientele for B learn about the company when they purchase the cheaper B product and as a result come back to purchase product A which is more expensive.  There can also be synergistic purchases simultaneously of the two products.  

Finally, there can be Supply chain, IT and HR synergies that exist that are not apparent in a financial analysis.  

The supply chain can suddenly become costlier because product A is smaller than product B and packing the trucks is more efficient when both are shipped together.  Suddenly the loss of B requires some changes in packing or packing and strapping that was not necessary in the past.  In addition, the shipping cost burden is now carried completely by A.  Another effect in a service perspective is that suppliers were delivering support for both products on an annual PO that considered a certain volume.  Eliminating B reduces the annual volume and a surcharge for services is now applied.  

For HR, the employees that produce or support B, can be trained on this product and once they are proficient, become product A support.  Or Product B can be a product that requires teamwork providing much needed rest from the stress of Product A activities for employees.  Simple producing or supporting A only can become tedious and fatiguing creating greater turnover.  

IT issues can become obvious after the product is discontinued.  For example, the MRP system that estimates the production or delivery of A can be set up using the two products/services for forecasting.  Once B is discontinued, assumptions in the MRP system about delivery, support and forecasting can be invalidated but not obvious to those running the system.  This can create some havoc to the forecasting and scheduling of operations.  

Finally, the strategic plan of the organization can be affected by the elimination of a product, service or division. How important that item up for elimination is to the overall strategy of the company should be a consideration.  It may well be a better choice to absorb the cost and invest in that marginal product rather than eliminating it from the company.  This decision requires a great deal of discussion and analysis beyond the financial.

Conclusion

The reason this situation has a name is because it is a known phenomenon in the operations area.  Good operations managers will know to ask a lot of questions when a product or service is on the chopping block due to financial issues.  Good board members should also know to ask these questions as well.  More commonly, financial managers are considered very experienced and knowledgeable and their recommendations about unprofitable divisions, products or services are often accepted with less than optimal pushback by leaders in organizations.  

The hazards of hollowing out are severe for companies that believe that they can save money and can create the beginning of their own demise instead.  Once this domino effect begins, it can be quite difficult to recover without large expenditures to retrieve business.  Clearly it is very important to look at all contributions a product, service or division is making across all divisions before elimination is the choice.  Bottom-line management can carry significant penalties for companies ignoring this advice.  

Written by Terri Friel



© Venture Connects 2017. Powered by PeopleVine. Terms of use | Privacy & cookies