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‘Fewer but stronger’ is motto for rationalization efforts

When confronted with a turnaround situation, operators and investors strive to implement near-term improvement initiatives to save the enterprise. These situations typically lead to such actions as SG&A reductions, capex abatement, recapitalization, supplier renegotiation, and selling price increases. Customer rationalization efforts are often overlooked as a valuable option in a turnaround manager’s toolbox. “Firing” a customer and foregoing sales dollars runs counter to many people’s spirit of commercialism.

Rationalizing a business’s customer base can be a quick and effective way to get a company’s economics back on track. At a high level, this effort can increase average selling prices (ASPs), reduce labor costs, increase production efficiencies and even handicap competitors, all resulting in improved EBITDA for the business. However, if not carried out prudently and methodically across a number of disciplines, a rationalization effort can expedite the demise of the enterprise.

Determining which customers to rationalize is the critical starting point of the initiative. To do so, detailed analysis must be done at a granular level to determine contribution margin by customer. This includes an understanding of profitability by product type and every variation thereof. Some businesses might already have profit by customer reporting capability. For those that don’t, this exercise requires coordination between the information technology (IT) department and financial analysts to pull the raw data, perform the analysis and develop a dynamic model to test various customer rationalization scenarios.

Avoiding standard allocations is critical. For input materials, drilling down to the bill of material (BOM) level is ideal. As for direct and indirect manufacturing labor costs, determining individual headcounts, their fully loaded compensation and how much time each person spends on each product type for a given manufacturing line or department is key. Every manufacturing line and department has varying efficiencies and variable cost components that must be considered in the model. Once unprofitable (i.e., negative contribution margin) customers have been identified, the economics of the resulting business must be modeled to determine the EBITDA impact to the enterprise.         

In a recent real-world example, a building materials manufacturer learned an appropriate customer rationalization effort could reduce its $1.5 million monthly EBITDA deficit to break-even. In addition to the decrease in revenue, a consultant modeled the economic benefits that would result from the decision, such as increases in ASP and production efficiency along with decreases in direct and indirect costs, delivery costs, and SG&A costs.

Once the financial modeling is complete and a rationalization plan is set, it’s time to execute the plan. Many aspects of implementation must be carefully considered to maximize the benefits of a customer rationalization effort.

Legal. A number of legal issues must be considered during a customer rationalization effort. Often, companies have supply agreements with their customers that involve minimum purchase order levels, rebate terms, and length of service time. Working closely with legal counsel to address such issues is important when developing the rationalization execution plan.

Additionally, during planning for direct labor staff reductions, legal counsel input is critical to ensure compliance with federal, state and municipal labor retention laws. Especially when a workforce reduction involves unionized employees, certain protocols must be respected.

Finally, when dealing with SG&A reductions, any existing employment contracts must be considered during the decision-making process. It is critical that a company understand and conform with all applicable contracts and associated laws when executing the plan.

Customers. Rationalizing customers is not as simple as telling them on the telephone that the company will no longer sell to them. The process involves determining necessary price increases on various product offerings that these customers purchase and delivering news of the price hikes as tactfully as possible.

In the case of the building materials manufacturer, many price increases that the consultant determined were necessary were in the 20 to 30 percent range. Such price hikes likely will provide more than enough incentive for a customer to look elsewhere for the product supply. A purchaser who doesn’t shop business around after such a price increase might be looking for another job shortly.

In some instances, however, customers will accept drastic price increases, which satisfyingly removes them from the rationalization list. It’s not unusual for a company to hear a customer say something like, “We were wondering when you were going to raise our prices.”

Operations. One of the largest drivers of customer rationalization success is operational execution. To keep cost of goods sold in check, the direct labor force must be scaled down in tandem with unit volume reductions. This requires a high degree of “flex” in a workforce and the ability to decrease overtime hours. Additionally, operators will likely need to identify additional cost-cutting to indirect labor and G&A areas. A decrease in volume likely yields opportunities to reduce headcount in areas such as planning, warranty support, delivery, warehousing, customer service, and accounts receivable. The motto should be “fewer but stronger.”

Furthermore, a reduction in production volume can provide a unique opportunity to improve manufacturing efficiency. A company can retain its best direct and indirect manufacturing laborers, those who have superior unit-per-hour metrics and the ability to flex up, down, and across assembly lines to help keep overtime hours to a minimum.

Similarly, a company can retain its best manufacturing equipment and decommission older machines, while optimizing the layout of the plant floor. Finally, a reduction in volume provides an opportunity to reevaluate the business’ network of warehouses and distribution centers. Ambitious operators should jump at the opportunities for operational improvements that a reduction in volume can uncover.

Sales. The customer rationalization effort requires a commensurate rationalization of the sales force. Management should not assume, however, that the sales people who oversee the accounts that are rationalized should be cut first. Rather, the entire sales force should be assessed, and only the best performers should be retained. After all, the new motto is “fewer but stronger.”

Sales people, especially top performers, tend to be the first to jump ship when turbulence strikes a company. Therefore, retention bonuses for the best sales representatives and managers should be put in place. Members of the sales force who survive the rationalization process have a great responsibility. They must counter the fear, uncertainty, and doubt (FUD) that will likely be spread by competitors to cast aspersions on the company’s sustainability to remaining customers, who are more important than ever in the wake of rationalization efforts.

The sales force also must play the role of distributor partner representative, encouraging rationalized customers to switch their business to one of the company’s distribution partners to satisfy any residual needs for the company’s products. Despite facing higher prices, a rationalized customer might develop a great relationship with one of the company’s distributors, resulting in retained business and a strengthened relationship due to volume referral. The sales force must view a rationalization effort as an opportunity to retain “fewer but stronger” customers.

Marketing/Communications. A company’s marketing and communications resources must be hard at work during a customer rationalization effort. A “fewer but stronger” message must be crafted that relays to the market, “We’re exiting some relationships that we’ve found to be unsustainable, but this effort will free resources to better serve our customers and channels that are most aligned with the strategic direction of our enterprise.”

This message must be ingrained in all outside-facing company representatives, including the CEO, CFO, head of human resources, legal counsel, vice president of sales/marketing, sales reps, etc. The message should be delivered via websites, blogs, social media, press releases, and in person, especially to remaining customers, who are key to the ongoing economics of the business.

Additionally, to counteract internal consternation, town hall meetings should be held to address employee concerns in interactive forums. Finally, the sales force should receive guidance on referring rationalized customers to specific competitors. This is a unique opportunity to direct unprofitable business to a company’s most threatening competitors, which not only could damage a competitor’s financial health, but could also reduce its available resources to lure away the company’s more profitable target customers.

Financial. Implementing a customer rationalization effort can have a dramatic impact on the financials of the business. Providing equity holders and lenders across the entire capital structure with the enterprise’s latest financial thinking pro formas, the responsibility of the CFO, is critical. This will help identify risk areas that might compromise the business’s ability to raise capital.

Any covenants or convertible debt triggers that are tied to revenue figures must be well understood. It’s important for the CFO to be as transparent as possible with the various stakeholders of the business by walking them through the financial impact of the plan. This offers an additional opportunity for the business to spread the “fewer but stronger” mantra that will result from the exercise.

Tracking and Metrics. Going through a customer rationalization effort requires meticulous tracking and reporting of metrics to maximize the probability of success. To ensure that unit volume ramps down appropriately, orders by customer must be tracked daily. To ensure that the appropriate direct labor workers are retained, labor efficiency metrics such as units-per-labor-hour must be analyzed. To ensure that the remaining customers are serviced better than they were before, on-time, complete, and various quality metrics must be tracked and managed.

As the “fewer but stronger” message is circulated in the marketplace, it is critical that every aspect of the business is tracked and reported, and that people are held accountable against these measurements. Once the appropriate metrics are decided upon and processes have been put in place to monitor and report, employee compensation must be firmly aligned with them. Indeed, supplementing the customer rationalization story with well-defined and meticulously tracked metrics can be key to instilling confidence among lenders and equity holders, who often find comfort in numbers.

A Powerful Tool

Rationalizing unprofitable customers can be a very effective mechanism to improve the economics of a business. It’s one of the most powerful tools a turnaround professional has to positively impact an enterprise in a relatively short period of time. To implement such an effort correctly, however, every aspect of the company must be taken into consideration and tracked diligently with relevant metrics.

At the end of the implementation, a business will have a smaller top line, but the bottom line will be stronger. Additionally, being “fewer but stronger” will provide a superior foundation to service the company’s remaining customers and to gain profitable market share from competitors as they scramble to service those least desirable rationalized customers.

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.

Cary Mailandt
Managing Partner
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