The world is still reeling from the impact of the COVID pandemic. To stem the crisis, governments around the globe implemented mitigation measures (aka economic lockdowns). These lockdowns caused significant reductions in income, a rise in unemployment, and disruptions in the transportation, service, and manufacturing industries. To survive, management/directors/boards have had to change the way they do business – the way they thought about their business.
Let’s see how this fits with the idea of Beyond Marginal Thinking…
At present, I do management accounting work for a medium-sized textile company, located outside of Moscow. Pre-lockdown, the company produced hosiery/socks for women, which in Russia, is a huge market.
Needless to say, when the lockdown occurred, sales plunged. The director was facing the real possibility of having to close doors and liquidate the assets. Hard decision – what would you do?
Instead of liquidating, the director came up with an idea of shifting production from hosiery/socks to producing face masks. The government was mandating that people wear masks, so he knew there had to be a huge demand. The director went with this idea and switched production. The masks were then sold to retail stores located in and around Moscow. This one decision generated enough cash flow so the company was able to stay afloat until hosiery/sock sales picked up.
What the director did – shifting production, was “thinking at the margins.” He had the equipment. He had the people. He had the materials (i.e. nylons, dyeing chemicals, etc.). He knew the contribution (selling price less variable cost) that would be made, so it was simply a matter of reprogramming the machines to produce masks instead of hosiery/shocks.
Marginal thinking requires decision-makers to evaluate whether the benefit of one more unit of something is greater than its cost. “If you think at the margin, you are thinking about what the next or additional action means for you – what it means for the contribution of the company.”
Example – If your company has the capacity and a customer wants to negotiate a discounted price per unit, then marginal thinking would be used to see the impact a discount would have on profitability. You would do this by calculating the contribution at a range of discounted selling prices.
For the director, liquidating the company was not a viable option, so, he did what was necessary to keep from having to close the factory doors. Considering that COVID was (is) a worldwide pandemic and the lockdowns occurred in most countries, there were thousands of managers facing the same dilemma as the textile director – “how to survive?” Unfortunately, many of these managers were not able to find a way to survive the lockdowns.
“If you need a machine and don't buy it, then you will ultimately find that you have paid for it and don't have it.” Henry Ford
As mentioned above, the lockdown caused textile sales of hosiery to plummet, causing serious cash flow problems. Fortunately, for the textile company, this problem was solved by shifting production until government restrictions were eased and the business could get back to producing its main product line. The shifting of production meant the director had to “think outside the box” - not accepting the status quo. This “thinking outside the box” took creativity; however, from a longer-term perspective, for companies to thrive and grow, they need to be constantly looking at ways to gain efficiencies. These gains are necessary to stay competitive. The problem is that this is not a one-time endeavor, it’s an everyday exercise. It takes what I call a “beyond marginal thinking” (BMT) mentality. Finance and accounting experts often refer to this as full cost thinking or absorption costing; however, I distinguish the two – BMT has to do with the way you “need to think” when making decisions, whereas, absorption costing is simply a costing system based on US GAAP or IFRS.
At the end of the day – shifting production was a short-term problem solver. The director’s strategy was to protect the business. Yes… he did this; however, the competitiveness of the hosiery market did not change, and due to the lockdown, probably increased. The result of the lockdown was that some smaller Russian producers were forced out of the market.
The way a BMT company thinks is not just marginal. A BMT company would ask itself - “If we had to start from scratch, how would we best build the company?” The problem with marginal thinking is that it doesn’t help develop new capabilities, which is what you would do if you were a start-up. For start-ups to survive, they need to be hungry - always looking for opportunities to exploit.
A good example of what I am talking about was highlighted in Clayton Christensen’s book “How Will You Measure Your Life?”
Christensen (1952 – 2020) was a professor at Harvard Business school and was the world’s foremost authority on disruptive innovation.
In the book, Christensen talks about U.S. Steel. Christensen describes how U.S. Steel watched one of its competitors, Nucor Steel, find new lower-level markets in the steel industry. The actions of Nucor Steel were eating into U.S. Steel’s market so a group of engineers at U.S. Steel got together and concluded that if U.S. Steel was going to survive, it had to build the kind of steel mills that Nucor had. These new types of plants are called “mini-mills.” These mini-mills were smaller but much more efficient than the legacy mills of U.S. Steel.
Recognizing the issues facing the company, the engineers at U.S. Steel put together a business plan, which “showed that U.S. Steel’s profit per ton would increase six-fold in the new plant.” Unfortunately, the CFO of U.S. Steel did not want to invest because of the investment cost it would take to build these mini-mills. He asked, “Why should we build a new mill. We have 30 percent excess capacity in our existing mills. The marginal cost of producing an additional ton in our existing mills is so low that the marginal profit is four times greater than if we build a completely new mini-mills.”
This is a case of the CFO thinking marginally. The CFO didn’t realize that by utilizing the existing plant, “they were not changing their fundamental cost of making steel at all.” Had U.S. Steel gone with the new plants, yes, there would have been the initial investment cost, but the company would have been building new capability to survive long into the future.
The five main processes for producing hosiery are
In the following, I briefly lay out three examples of where the textile director was not thinking marginally. If he had been – his effort would have been spent on increasing production to lower per-unit cost. Instead, he…
Pre-lockdown, the dyeing facility was located some 35 km from the factory. The time spent to transport, dye the hosiery, and transport the goods back to the factory added an extra 2-3 days to the production process.
During the lockdown, the manager took the plunge and moved the dyeing facility to the factory. He found space in the factory and found people within the company to redesign part of the factory to accommodate the dyeing equipment. There were also issues of control over the quality and timing spent for testing new colors.
One time during the lockdown when I had to work from home, I talked with the manager. He said, "you will never guess what I did." “I moved the dyeing facility to the factory.” At first, I thought he was kidding because I didn’t think it was possible. Preliminary investigation showed that to move the dyeing facility to the factory would be some $500,000+, including the construction of a new building and meeting environmental regulations, but he did it for 1/10th the cost.
Estimated annual cost savings - $100,000+
The boarding process takes steam so the hosiery items are ready to be packaged. Pre-lockdown, the means of generating steam heat was through the use of a diesel generator. Even in Russia, the cost of diesel had been steadily rising through the years so pre-lockdown, the cost of steam was becoming a burdensome cost for the company. What did the manager do?
In Russia, gas is a readily available source of energy and much cheaper than diesel. It was a matter of finding the nearest gas line and running a line to the factory. This did take a sizable investment, but the benefit was enormous. As of today, the cost of gas as compared to diesel is about two-thirds less. If you put that on a per-unit basis this gives the company additional cost competitiveness.
Estimated annual cost savings - $50,000+
My final example has to do with the director’s attempt to lower electricity costs. To operate at maximum efficiency, the knitting machines require a constant temperature of 23-25C and humidity of 62-65%. In the past, the air conditioning system consumption was approximately 140 kWh per hour consisting of two electric motors. To cut back consumption, the manager came up with the idea of isolating the knitting machines by constructing a separation wall and installing a ceiling over the knitting machines. Based on this, electricity consumption should reduce to about 80 kWh per hour. This is an approximate 43% drop in electricity consumption.
Estimated annual cost savings – $20,000+
Overall, the annual cost savings of these three actions could amount to more than $170,000, which for a small textile company is significant.
If I were to identify the characteristics of a BMT company, I would say this, a BMT company…
My next article will be “Challenges of Growing Your Business.” As sales increase so do the headaches of having to maintain control over the company. In this article, we explore the phases that companies typically go through as they grow from a start-up to a multi-national corporation.