Author: Gisele Garraway
Contributor: Steve Berez
Profitability
Product Line
March 1998
CU7030298IMB
CU7020998JZA
CU7020998JZA
Product Line Profitability
Agenda
PLP overview
Applications
PLP steps
Client example
Challenges
Key takeaways
CU7020998JZA
Product Line Profitability
PLP overview
Applications
PLP steps
Client example
Challenges
Key takeaways
Agenda
CU7020998JZA
Product Line Profitability
PLP Description
Product line profitability (PLP) is a diagnostic tool that helps us determine the “true” profitability of each product within a multi-product portfolio.
Picture Frames
Operating Margin
%
%
%
%
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Product Line Profitability
Profit Improvement Tools
PLP analysis is one of the Bain diagnostic tools that can identify sources of profit improvement.
0%
5%
10%
15%
20%
1
2
5
Profitability
Relative Market Share
Bain profit improvement tool kit
PLP
BDP
RCP
VMR
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Profit Line Profitability
Why Bain Uses PLP
Senior managers can use PLP analysis to make important decisions about product lines.
For which products should we increase prices?
Where should we focus our cost reduction efforts?
Which product lines should we drop?
Which products should we focus R&D efforts on?
Where should we provide sales incentives?
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Product Line Profitability
Typical Accounting System Versus Bain PLP
Unlike typical accounting systems, PLP involves driving below gross margin and allocating costs to get to an operating margin for each product line.
Typical accounting system
Bain PLP
Cost collection:
By function (. R&D, advertising)
By product line
Cost assigned to products:
Cost of goods sold
direct labor
direct materials
All costs, including all indirect costs
overhead
advertising
distribution
Key product profitability measure:
Gross margin (revenue - cost of goods sold)
Operating margin
Cost allocation method:
Accounting standards
Activity-based cost drivers
Disadvantage:
Often does not reflect true commitment of resources and the returns for their use
Difficult to capture all activities that drive costs
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Direct and Indirect Costs
Traditional accounting systems often allocate only direct costs, not indirect costs, to products. And, in some cases, the direct costs are allocated inappropriately.
Indirect costs
Direct costs
Definition
Typical accounting
allocation
PLP
allocation
Costs generally incurred by the firm outside of the production process. These cannot easily be identified with or assigned to a particular product
Costs incurred directly in the production of the product or service. These costs can easily be identified with a particular product
Not allocated or allocated based on percent of sales
Allocated based on actual cost drivers
Tracked using accounting standards
Variances sometimes not tracked by product
All direct costs, including variances, are tracked by product
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Inappropriate Direct Cost Allocation
Some accounting systems allocate direct costs to products based on original expectations about production results. These assumptions cannot account for changes in raw materials use and labor time.
Accounting standard
Actual for last quarter
Difference
Revenue per widget:
$
$
Raw materials:
$
$
Standard excludes loss
Increased loss due to change in supplier quality
Production floor labor:
hours x = $
hours x = $
Standard excludes switch- over from main produce
Increased labor due to rework from lost
Gross margin:
- ( + ) =
- ( + ) =
Gross margin percent:
31%
8%
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Gross Margin Versus Operating Margin
If accounting systems do not allocate all indirect costs to products, managers may misjudge products’ relative contribution to profits.
Indirect costs
Price:
$750
$600
$450
Gross margin:
40%
33%
44%
Operating margin:
29%
20%
23%
On a gross margin basis, J-88s are the most profitable; however, T-54s are most profitable when all indirect costs are allocated
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Potential for Mismanagement
Failure to tie direct and indirect costs to individual product lines can cause firms to mismanage their businesses.
Sales and marketing
Distribution
Product development
Spend advertising dollars on wrong products
Set up compensation and incentives to encourage sales of unprofitable products
Prioritize delivery schedules inappropriately
Establish wrong truck load ratios
Fund unprofitable products
Kill profitable products
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Paths to Low Profitability
Multi-product businesses that do not understand their products’ true profitability become low profit firms.
If gross margins are based on inappropriate accounting standards and indirect costs are not allocated appropriately
High gross margin (potentially low net profit) products are given investment capital
Low gross margin (potentially high net profit) products are starved of investment capital
New product line extensions are introduced
Additional complexity from growing number of SKUs increases direct costs
Product line extensions are ignored and profitable products’ growth slows
Poor profitability continues, driving high prices and poor positioning versus competitors
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Product Line Profitability
PLP overview
Applications
PLP steps
Client example
Challenges
Key takeaways
Agenda
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Product Line Profitability
Applications
Bain has used PLP extensively. Some examples of our work include:
Air transportation
Communications
Situation:
An air transportation company had various lines of business, but no activity-based accounting system. Management did not know which businesses, routes, or customers where profitable
After suffering four consecutive years of negative net income, a voice processing service company was interested in understanding the economics and market positioning of their product lines
Result:
Bain identified unprofitable businesses, routes, and customers which in some cases were subsequently cut or pricing was altered to improve profitability. An analysis of costs indicated that profitability was much worse than thought, leading to a mandate for company-wide cost reduction and revenue enhancement
Bain assessed the profitability of three major product lines and identified savings of $20-$25MM on a cost base $110MM
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Product Line Profitability
PLP overview
Applications
PLP steps
Client example
Challenges
Key takeaways
Agenda
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Product Line Profitability
PLP Steps
PLP analysis involves six major steps.
Understand client’s current P&Ls and cost collection systems
Determine the major activities performed
Identify costs and cost drivers for each activity
Allocate costs to each product
Analyze profitability by product or group of products
Make recommendations
Key Success Factors
Identify all people and systems that report financial data
Understand linkages among and differences between the various sources of data
Tie costs to operations, not accounting categories
Focus on the largest cost elements
Quantify drivers for each product
Pressure test assumptions with clients
Calculate over several years or periods to eliminate any seasonal or one-time effects
Make sure absolute profit of product lines can be reconciled with the total business’ profits
Consider strategic and operational alternatives
Map the client's value chain from beginning to end
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Kelly's Gourmet Jellies - Background
PLP could be used to help Kelly’s Gourmet Jellies understand the profitability of its jar versus bucket business.
Situation:
Kelly’s Gourmet Jellies is a regional producer of high-quality, premium priced fruit jellies. Kelly’s has two major product lines:
8-oz jars to grocery stores for retail sale and
1 gallon buckets to universities, hotels, restaurants, and country clubs
Complication:
Indirect costs are not allocated to products
Question:
Are 8-oz jars more profitable than gallon buckets?
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PLP Steps
Understand client’s current P&Ls and cost collection systems
Determine the major activities performed
Identify costs and cost drivers for each activity
Allocate costs to each product
Analyze profitability by product or group of products
Make recommendations
Key Success Factors
Identify all people and systems that report financial data
Understand linkages among and differences between the various sources of data
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Kelly's - Sources of Cost Information
An important first step in PLP analysis is understanding the client’s financial reporting system.
Order database
Contents
Report Timing
Responsibility
Quantities of jars ordered by customer
Quantities of buckets ordered by customer
Price per order
Weekly
Marketing/sales analyst
Monthly
manufacturing summary
Ounce production by flavor
Employee time reports
Monthly
Kitchen supervisor
Expense report/vendor payments system
Storage inventory
Ingredient invoices
Utility payments
Monthly
Accounting analyst
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Kelly's - Current Profit Reporting
Kelly’s current accounting system shows that on a gross margin basis, 8-oz jars are more profitable than one gallon buckets. Overall, Kelly’s earns a % EBIT margin.
Sales:
$468,000
$252,000
Gross margin:
$243,360
$105,840
Kelly’s Gourmet Jellies Profit and Loss
Jan-Dec 1996
Sales
Cost of goods sold
Gross margin
$720,000
($370,800)
$349,200
Operating expenses
($281,334)
EBIT
$67,866
EBIT margin
%
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Kelly's - Operating Expenses
Over $280K of operating expenses are not allocated to jars or buckets.
Labor
Kitchen maintenance
Administrative
Warehouse
Delivery
Sales commission
Maintenance supplies - kitchen
Maintenance supplies - trucks
Utilities - kitchen
Utilities - warehouse
Depreciation
Kitchen equipment
Warehouse
Office equipment
Delivery equipment
Selling expenses
Other G&A
$5,955
$12,262
$6,590
$15,880
$56,880
$5,955
$1,985
$3,375
$12,706
$26,206
$7,624
$2,621
$11,117
$79,413
$31,765
$281,334
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PLP Steps
Understand client’s current P&Ls and cost collection systems
Determine the major activities performed
Identify costs and cost drivers for each activity
Allocate costs to each product
Analyze profitability by product or group of products
Make recommendations
Key Success Factors
Map the client's value chain from beginning to end
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Kelly's Jellies - Process Flow
Typically management interviews and plant tours help delineate the key activities that drive costs.
Preserving
Storing
Selling
Delivery
Corporate Functions
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Product Line Profitability
PLP Steps
Understand client’s current P&Ls and cost collection systems
Determine the major activities performed
Identify costs and cost drivers for each activity
Allocate costs to each product
Analyze profitability by product or group of products
Make recommendations
Key Success Factors
Tie costs to operations, not accounting categories
Focus on the largest cost elements
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After key activities are determined, all costs should be assigned to activities. Next, the cost driver will determine how costs should be allocated.
Activity
Costs
Allocation/cost driver
Rationale
Preserving
Maintenance labor
Maintenance supplies
Utilities - kitchen
Equipment depreciation
$5,955
$5,955
$3,375
$26,206
$41,491
Ounces
Both products use the same jelly, so ounces is the best proxy for relative use of equipment and facilities
Boxes of jars and buckets can be stacked on top of each other
Storing
Warehouse labor
Utilities - warehouse
Warehouse depreciation
$6,590
$12,706
$7,624
$26,920
Cubic feet
Kelly’s - Cost Drivers
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Product Line Profitability
Activity
Costs
Allocation/cost driver
Rationale
Commissions are directly assignable. Most expenses directly assignable to a channel (and therefore to a product type)
Selling
Sales commission
Selling expenses
$56,880
$79,413
$136,293
Actual costs; ounces
Labor is the key item and manhours drive labor cost. Possibly depreciation could be more accurately allocated using cubic feet shipped
$15,880
$1,985
$11,117
$28,982
Delivering
Delivery labor
Maintenance supplies - trucks
Truck depreciation
Manhours
Probably the simplest unit for allocation
Corporate functions
Administrative labor
Office equipment depreciation
Other G&A
$6,590
$12,706
$7,624
$26,920
Ounces
Total operating expenses:
$281,334
Kelly’s - Cost Drivers
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Product Line Profitability
PLP Steps
Understand client’s current P&Ls and cost collection systems
Determine the major activities performed
Identify costs and cost drivers for each activity
Allocate costs to each product
Analyze profitability by product or group of products
Make recommendations
Key Success Factors
Quantify drivers for each product
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Kelly's - Cost Driver Collection
Next, the key cost driver measures for each product must be collected to determine how to allocate costs among the products.
Ounces produced and sold:
8-oz jars
One gallon buckets
Total
Data source
1,248,000
1,075,200
2,323,200
VP, sales
Labor hours required to deliver 1MM oz of jelly:
24 hours
10 hours
Delivery supervisor track schedules
Average warehouse storage requirements:
3,100 cubic feet
1,900 cubic feet
5,000 cubic feet
Stock supervisor
Sales commissions:
% sales
4% sales
VP, sales
Selling/promotional
expenses:
to retail (jars only)
to institutions (buckets only)
to public (jars and buckets)
73,795
1,638
VP, sales
3,980
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Product Line Profitability
Kelly's - Cost Allocation ()
*Total costs for activity minus the costs allocated to jars
Once cost driver measures are collected for each product, it is relatively straightforward to allocate costs.
Sales:
COGS:
Gross margin:
8-oz jars
One gallon
buckets
468,000
224,640
243,360
252,000
146,160
105,840
Preserving costs:
[1,248MM oz/2,323MM oz] x 41,491=22,290
41,491 - 22,290=19,201*
Storing costs:
[3,100 cu ft/5,000 cu ft] x 26,920=16,690
26,920 - 16,690=10,230
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Product Line Profitability
Kelly's - Cost Allocation ()
8-oz jars
One gallon
buckets
Delivery costs:
[1,248MM x 24hrs/MM oz] /
[( x 24) + ( x 10)] x 28,982 = 21,327
28,982 - 21,327=7,655
Selling:
commission
promotions
468,000 x 10%=46,800
252,000 x 4%=10,080
73,795 + [( x 3980] - 75,933
1,638 + (3,980 - 2,138)=3,480
Corporate overhead:
[ x 47,648=25,598
47,648 - 25,5978=22,050
Total operating expenses:
EBIT
208,638
34,722
72,696
33,144
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Product Line Profitability
PLP Steps
Understand client’s current P&Ls and cost collection systems
Determine the major activities performed
Identify costs and cost drivers for each activity
Allocate costs to each product
Analyze profitability by product or group of products
Make recommendations
Key Success Factors
Pressure test assumptions with clients
Calculate over several years or periods to eliminate any seasonal or one-time effects
Make sure total absolute profit can be reconciled with client’s calculations
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Kelly's Jellies - PLP Results
PLP results revealed that one gallon buckets are more profitable than jars.
Current Accounting System
PLP
Buckets have:
Lower warehousing costs
Lower promotional costs
Lower selling commissions
Lower labor costs in stocking and delivery
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Product Line Profitability
PLP Steps
Understand client’s current P&Ls and cost collection systems
Determine the major activities performed
Identify costs and cost drivers for each activity
Allocate costs to each product
Analyze profitability by product or group of products
Make recommendations
Key Success Factors
Consider strategic and operational alternatives
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Product Line Profitability
Options for Underperforming Products
If a product line is unprofitable or profitable but underperforming, there are five alternatives to consider.
Can we reduce costs?
Can we increase price?
Can we increase volume?
Should we keep product as a loss leader?
Should we drop the product?
What is our relative cost position?
Where is our relative disadvantage?
How price sensitive are customers?
How will competitors respond?
Will a price increase encourage the entry of new competitors?
Have we fully penetrated existing accounts?
Have we aggressively targeted new accounts?
Is the product an effective loss leader?
What will be the cost impact on other products?
How will competitors react?
How will customers react?
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Kelly’s - Recommendations
PLP analysis can provide operational improvement tactics for Kelly’s Jellies.
8-oz jars
Gallon buckets
Re-negotiate promotion programs with key accounts
Lower sales commissions
Set higher product price
Re-route delivery schedules
Increase sales commissions
Grow customer base - encourage new accounts
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Product Line Profitability
Agenda
PLP overview
Applications
PLP steps
Client example
Challenges
Key takeaways
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Product Line Profitability
Vulcan* - Background
*Disguised client example
Bain used PLP analysis to help a $300MM aluminum manufacturer understand where it made money and where it needed to focus its growth initiatives.
Coated sheet
Foil
Uses:
RVs, campers, buses,vans, roofing, siding, garage doors, manufactured homes
Consumer durables, disposable cookware and food containers, pharmaceutical packaging
Client situation:
Becoming more of a commodity business with tough pricing pressure
Considered more profitable than coated sheet product line
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Vulcan - Sales
Source: 1991-1997 Income Statements
Sales declined sharply from a 1994 high, although 1997 shows some signs of improvement.
CAGR
(1991-94)
CAGR
(1994-97)
Sales
Volume
%
()%
()%
%
%
()%
CAGR
(1991-94)
CAGR
(1994-97)
%
()%
()%
%
%
()%
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Vulcan - EBIT
Source: 1991-1997 Income Statements
EBIT was projected to increase in 1997, but to remain far below 1994-95 levels.
CAGR
(1991-94)
CAGR
(1994-97)
EBIT/ sales:
%
%
%
%
%
%
%
%
()%
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Vulcan - Process Flow
The Bain team visited a key plant and interviewed manufacturing employees to understand the key activities and process flow. Coated sheet and foil products went through a similar process up to the rolling phase.
Melting
Casting
Coiling
Foil rolling
Ship
Coating
Ship
Ingots
Rolling
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Vulcan - Total Petersburg Costs
Source: 1996 Income Statement; PLP Model
The Bain team’s first step was to understand Vulcan’s total costs and their relative importance. The team studied a representative facility, Petersburg.
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Vulcan - PLP Methodology ()
Revenue:
Actual revenue by order item
The team went through each cost component and developed a methodology to allocate costs to foil and coated sheet products.
Conversion:
Adjust standard hours by part-number and method-number for each piece of equipment using November 1996 and March 1997 actual vs. standard hours comparison
capture actual operating hours for each piece of equipment using revised equipment time sheets
determine how accurately standards capture actual hours
understand drivers of difference between standard and actual
calculate adjustment factor to apply to full year 1996 by each piece of equipment
Paint:
Actual paint cost by part-number and method-number
Metal:
Use daily bookings data to assign actual primary metal price by customer sales order
Use actual price/lb for alloys and hardeners
Add melt and dross loss by alloy type
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Vulcan - PLP Methodology ()
Freight:
Actual freight costs by order item
Working capital:
Actual accounts receivable by general product category (foil vs. coated sheet) and finished goods by part-number method-number
Selling:
Allocated by actual salesperson’s time spent by market
G&A:
Allocated as a percentage of sales dollars
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Vulcan - Petersburg Material Costs
Source: Petersburg Metal Receipts
The Bain team began by examining the largest cost area, direct materials.
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Vulcan - Matching Data
Since metal price was not captured in the shipments database, it had to be matched with the bookings database to get an accurate metal price.
1996 Daily Sales Bookings Data
1996 Order Items Shipped Data
Order date
Promised date
Customer name
Ordered lbs
Unit sales price
Fixed/float metal price
Order date
Original promise date
Customer name
Ordered lbs
Unit sales price
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Vulcan - Total Metal Costs
*Dross is the non-usable scum that rises to the top when aluminum is melted
From manufacturing interviews, the team learned that the total actual metal cost would be affected by the melt and dross* loss associated with foil and coated sheet.
Primary metal
Melt and dross* loss
Actual metal cost
+
Actual alloys and hardener cost
Use industry standard mix
+
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Vulcan - Conversion Cost Methodology
*Method-number distinguished among the various routings a product could take through the mill’s equipment
Conversion costs were driven by production and support function activities.
Actual conversion cost
Fixed
Variable
Fixed
Variable
Production
Support
., hot mill
Cold mill 3
Chester mills
Henrico mills
., MIS
Accounting
Building and grounds
Scheduling
Directly assigned to equipment
Allocated to part number by fixed cost drivers
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Vulcan - Conversion Cost Sources
*Method-number distinguished among the various routings a product could take through the mill’s equipment
The team used several Vulcan sources to build conversion costs from the bottom up.
Actual conversion cost by production and support cost centers
Fixed/variable splits from management interviews
Production data by production cost center
Standard operating hours and pounds
By part-number and method-number*
Revised equipment time sheets by production cost center
Actual operating hours by output work order item
November 1996
February-March 1997
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Vulcan - Production and Support Costs
Vulcan finance managers agreed to the methodology of assigning production and support dollars.
Production dollars
Directly assigned
Support dollars (., MIS, accounting)
+
Allocated within each piece of equipment by actual hours
Allocated by fixed cost drivers
Step 1 - Equipment cost center:
Step 2 - Part-number/ method-number:
Actual conversion cost
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Vulcan - Actual Hours Methodology
Another methodology was required to adjust standard hours to the actual hours spent converting the ingots to foil or coated sheet.
Actual production data
Plant personnel experience
Model accuracy of standards
Determine cost drivers
Adjust standard hours based on cost drivers
Actual hours by part-number and method-number
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Vulcan - Fixed Cost Drivers
Allocation Method
By pounds
By pounds
By sales dollars
By pounds
MIS
Traffic
Purchasing
By pounds
weighted for foil
weighted for coated sheet
The team developed an allocation method for fixed costs, too.
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Vulcan - Total Conversion Costs
Source: 1996 Plant Cost Summary Report
The team allocated conversion costs to foil and coated sheet.
Coated
Foil
MIS
Accounting
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Vulcan - Product Line Profitability
Source: Bain Product Line Profitability Model
Foil contributes most of the total gross margin dollars.
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Vulcan - Profit Before Tax
Source: Bain Product Line Profit Analysis
Foil contributed all of Vulcan’s profits. Coated sheet lost over $.
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Vulcan - Recommendations
The team used the PLP results to make specific recommendations for Vulcan’s products.
Coated sheet
Foil
Give second priority to coated sheet product on bottleneck equipment
Identify opportunities for cost reduction
Grow the foil business
look for new segments
Invest in foil capacity
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Agenda
PLP overview
Applications
PLP steps
Client example
Challenges
Key takeaways
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Product Line Profitability
Challenges
There are a few key strategies to keep in mind when dealing with PLP-related data and client issues.
Data issues
Client (people) issues
Do not draw conclusions based on a single year or period of data; instead analyze more than one year or period to eliminate one-time effects or seasonal effects
When making projections based on PLP analysis, remember different products will have different E-curves and different Bain slopes (their costs will decline at different rates)
Spend time on every cost component, but focus on areas that affect the answer; PLP analysis takes time, so prioritize
Get buy-in of finance managers early in the process; they are often needed to supply most of the data
Be sensitive - PLP analysis often implies that clients have been misinterpreting their financial results for years
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Agenda
PLP overview
Applications
PLP steps
Client example
Challenges
Key takeaways
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Product Line Profitability
Key Takeaways ()
The Basic Principle
Why Bain Uses PLP Analysis
Product line profitability (PLP) is a diagnostic tool which determines the true profitability of each product within a multi-product portfolio
PLP is a process of allocating all costs to products based on the activities that drive those costs
PLP addresses some of the shortcomings of traditional accounting - derived profitability measures
Traditional accounting systems often only allocate direct costs to products. These systems only provide gross margin by product
Often gross margins are based on pre-set standards, not actual cost drivers, in traditional accounting systems
Managers may misjudge products’ relative contribution to profits when only gross margin and not operating margins are calculated by product
Without understanding products’ profitability, indirect costs often rise unchecked and firms will introduce more SKUs to cover fixed costs
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Key Takeaways ()
PLP Steps
PLP analysis involves six major steps:
understand clients’ current P&Ls and cost allocation systems
determine the major activities performed
identify costs and cost drivers for each activity
allocate costs to each product
analyze profitability by product
make recommendations
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Business Definition
Takeaway Slides ()
PLP Description
Direct and Indirect Costs
Typical Accounting System vs. Bain PLP
Paths to Low Profitability
%
%
%
%
Picture Frames
Typical accounting system
Bain PLP
Cost collection:
By function (. R&D, advertising)
By product line
Cost assigned to products:
Cost of goods sold
direct labor
direct materials
All costs, including all indirect costs
overhead
advertising
distribution
Key product profitability measure:
Gross margin (revenue - cost of goods sold)
Operating margin
Cost allocation method:
Accounting standards
Activity-based cost drivers
Disadvantage:
Often does not reflect true commitment of resources and the returns for their use
Difficult to capture all activities that drive costs
Direct costs
Costs generally incurred by the firm outside of the production process. These cannot easily be identified with or assigned to a particular product
Costs incurred directly in the production of the product or service. These costs can easily be identified with a particular product
Not allocated or allocated based on percent of sales
Allocated based on actual cost drivers
Tracked using accounting standards
Variances sometimes not tracked by product
All direct costs, including variances, are tracked by product
Definition
Typical accounting
allocation
PLP
allocation
Indirect costs
If gross margins are based on inappropriate accounting standards and indirect costs are not allocated appropriately
High gross margin (potentially low net profit) products are given investment capital
Low gross margin (potentially high net profit) products are starved of investment capital
New product line extensions are introduced
Additional complexity from growing number of SKUs increases direct costs
Product line extensions are ignored and profitable products’ growth slows
Poor profitability continues, driving high prices and poor positioning versus competitors
Operating Margin
CU7020998JZA
Business Definition
Takeaway Slides ()
PLP Steps
Challenges
Understand client’s current P&Ls and cost collection systems
Determine the major activities performed
Identify costs and cost drivers for each activity
Allocate costs to each product
Analyze profitability by product or group of products
Make recommendations
Key Success Factors
Identify all people and systems that report financial data
Understand linkages among and differences between the various sources of data
Tie costs to operations, not accounting categories
Focus on the largest cost elements
Quantify drivers for each product
Pressure test assumptions with clients
Calculate over several years or periods to eliminate any seasonal or one-time effects
Make sure absolute profit of product lines can be reconciled with the total business’ profits
Consider strategic and operational alternatives
Map the client's value chain from beginning to end
Data issues
Client (people) issues
Do not draw conclusions based on a single year or period of data; instead analyze more than one year or period to eliminate one-time effects or seasonal effects
When making projections based on PLP analysis, remember different products will have different E-curves and different Bain slopes (their costs will decline at different rates)
Spend time on every cost component, but focus on areas that affect the answer; PLP analysis takes time, so prioritize
Get buy-in of finance managers early in the process; they are often needed to supply most of the data
Be sensitive - PLP analysis often implies that clients have been misinterpreting their financial results for years
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