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Evaluating products. The marketing financial plan. © Copyright by Victor Aquino, 2001, 2006 WEA Books & Publishing Inc. Monroe, LA USA
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The difficult commercial situation of current days and the increasing uncertainty of the future markets bring forth that the majority of the companies should revaluate today's potential of their line of products. The functions of auditing the line of products are: (a) improve the current performance increasing the yield of the line; (b) provide for future performance, discarding obsolete products and summing new ones which capitalize the opportunities of future markets.
Instead of having a regular and systematic evaluation, the majority of the companies only give attention to the current performance and the potential of their products when errors become apparent. Even so, the making of an efficient decision is usually jeopardized by inadequate information about the yield of the line of products and by a deficiency on examining the interdependences which exist among the products within a line. The cost of not making a periodic audit of the set of products is the company's unbalance. What this specifically mean, is that a line gets overloaded with the so called "yesterday's sure profit products" - products which have declined and have gone beyond their medium livelihood, and fails with the "tomorrow's sure profit products" - new products fitted out to the increasing market of the future years. The effects are an inadequate yield and a non-equipped company to face the forthcoming challenges. This essay details the necessary information to identify, ahead of time, the problems of a set of products and the type of analysis useful for the solution of these problems, and to capitalize the opportunities which come about.
Finally, it evaluates the opportunities of new products, giving special attention to the inevitable interdependencies among the new products and the existing ones already in line.
NEEDS FOR SYSTEMATICAL REVISION
The performance of a line of products should be kept under constant revision. A variety of reasons may be given for a systematic audit: (1) The potential profit of many products was violently reduced by the impact of an unexpected severe inflation in the cost. (2) A slower economic growth means that I the forecasted opportunities of the market were not accomplished. Therefore, the set of products should be rapidly changed and stabilized to reflect the new situation, so as to avoid losses and to seek new opportunities.
(3) We know, through the phenomenon of the vital cycle of a product, that all products virtually have a limited life span and go through well defined phases such as introduction, growth, maturity and decline. As much as profitable a product would have been, it will inevitably be modified or substituted by new products. (4) Without a systematic revision, an administrative inertia permits that declining products continue lasting to the detriment of the company's interest. The hope for the declining product to grow again, or such arguments as, that at the moment, there are no opportunities for be tier profits, are frequently reasoning of an inefficient administration. (5) Weak products ha ye disguising costs. They tend to consume excessive administrative time and to require sale and advertisement support which produce better results if directed to more powerful products. (6) The majority of the companies apply the 80: 20 rule 80 percent of
the results are general teed by only 20 percent of the products. As an overall, substantial profits can be gained by concentrating on products which will be present and future "winners". We call this: the prior decision of the administration specifically: greater support, in quantity and quality, to the more powerful areas concerning opportunities and results, before a next promising area receives any amount.
STANDARDS FOR EVALUATING PRODUCTS
The products' revision foundation is the company's continuous information about the financial performance. Three financial standards demonstrate efficiently the problems of a set of product. The contribution to the profit and the general expenditures brought by the product are the crucial indicator of its performance. Observe the fact that this concept is quite different from gross margin and net profit which appear on the ordinary accounting. They have two basic defects which turn then into misleading directives for the control and the decisions of marketing. For an industry of diversified lines of products, it initially achieves the gross and the net profit deducing the general manufacturing expenses which are based on arbitrary allocations among the products.
There is no way to allocate, in a scientific manner, the costs of production and marketing, when referring to a set made up of various products on the same line. As a consequence, there is not an exact evaluation of the profits of the product. Different methods of allocation commonly in terms of yield, will bring about different arrangements for the products. The second defect of these criteria is that; not being able to distinguish the variable costs from the fixed costs, there is no way to determine the increasing profit of the modifications in the market as a whole. The indicator of the costs of the sold goods used in the conventional accounting to find the gross profit, includes the general expenses of manufacturing which do not vary with the modifications in the sales. These things can be shown using a disguised and simplified accounting from a nationwide known industrial company had an annual output of 38 million, brought up by 4 major lines of products. Each line was composed by a number of products intimately interrelated - 32 in all. There were 30 salesmen, and each sold all the products in a given geographic area. Figure 1 demonstrates the results for the year which is being examined. Notice how the accounts
separate the variable costs from the fixed costs and concentrate on the contribution to the profit.
Figure 1 The budget of variable line products
The variable costs enclose from labor to materials, which can be directly related to the produced units and also certain manufacturing and commercial costs which vary during the year, depending on the level of production. It's Include certain specific costs of maintenance, quality control and certain labor costs, which can vary with the number of transactions. The general costs are divided into specific programs of costs which occur each year, as a result of a corporate decision for a given line. Fixed and general program costs to all the lines are fundamental, considering that the company is functioning. The two last types of costs are unquestionably subjected to arbitrary allocations of the lines and consequently are separated from those specific costs of the line. The indicator of the contribution to the profit has various important uses. At first, it hands a relatively objective evaluation of the impact of new orders on the profit. For example, based on current prices, 36 percent of increased sales on line D represent a contribution to the profit and general expenses, whereas only 8 percent are of line A. After deducing the costs of specific programs, its contribution to the general fixed
expenses and to the programs is of 16 percent and of - 3 percent. Therefore, it is very clear that when possible, it compensates to direct marketing efforts to line D. Nevertheless, sales on any profitable line give a greater profit than if these sales were not made. The results also permit an analysis of the modifications on the set of products. In mature markets, many a times, it is easier to do this than increasing total sales. Figure 2 demonstrates that the potential impact over the net profit, by eliminating line A, is the redistribution of the marketing efforts over the other there more profitable lines. Figure 2 Impact of volume changes inset over profits
Considering that the variable costs can generally be traced to each product, the contribution to the profit should be calculated for each item of the line. If this is done, it is useful to calculate the Curve of Lorenz (Figure 3) which shows which of the products are generating the greatest volume of contribution.
Figure 3 Lorenz diagram for products' set
In this case it was found 25 percent of the products generated 80 percent of the contribution. A significant number of projects were making negative contributions whereas the majority of the products were giving little profit. The Lorenz Curve is an excellent method to demonstrate, to the board of directors, which of the cost permit the increase of products in the set. If the company is operating at almost full capacity and certain retarding conditions appear, the contribution itself is not sufficient to evaluate the performance of the product. Two products may generate the same contribution, but one may demand much more time of the few manufacturing installations. In this situation, the profits can be increased by producing more of the economical product in terms of deficient installations. These resources may be equipment's, materials (for example, during the lack of sugar in 1974) or tine of sale. Contribution, per time of processing, is calculated by dividing the generated contribution of a given demand by the number of hours of deficient equipment (or quantity of material) necessary to produce the goods. The performance should be related to the invested capital used to back the variable cost. As long as line V has a high indicator to the
contribution, a high operational and fixed cost investment is demanded to back this line. Unless the total sales should be impelled, line V will represent the minimum return to the investors. Notice that while the contributor and the contribution per hour of equipment may be calculated for individual products, it is rarely possible to calculate the return of the investment, below the level of the division or line, because the products tend to use installations as whole.
STRATEGY AND TACTICS
As inadequate financial performance in terms of these there criteria identify the problematic products, but the income requires a more precise diagnosis of the problems and other methods to solve then. The following factors must be studied after the initial choice. The data for any particular month or year may not be the real reprehensive ones. Monthly data may be influenced by seasonal movements and a weak year may be a result of cyclic fluctuations around a tendency of growth. It is necessary to examine the contribution and the return over the investment for a valid period of time, before making useful forecasts of the potential. The specific sources of deficiency of a product should be isolated. This demands a division of the total contribution of the product in focuses of responsibility (division district, area of sales), distribution (wholesale, direct) and individual clients.
With this information, the three alternatives, when trimming the product may be evaluated. First, the reduction of the costs may be explored. Today's inflation and scarcity show unexplored opportunities for the use of other cheaper materials, so as to obtain a competitive advantage. Secondly, it is possible to achieve a greater efficiency in marketing. Many times, for former products, it is possible to reduce the sales and advertising costs. Finally, the company may try to improve the product if it considers that the market has sufficient potential to compensate the investment and that it will not be immediately run down by imitations of the competitors. The analysis of the equilibrium point is a useful technique to explore the financial implications of the different methods for the increase of efficiency. It must be considered implications of the trimmings of a product over the others in the line. The interrelated demands within a line, may imply that one product contributes more than it seems to. The promotional advantages of a complete scale of products may sometimes mean that "whole" is greater than the sum of the parts. However, before accepting this argument of main taming a contributor weak, the administration should evaluate he possibility
of reacquiring the product by a smaller price, than that of manufacturing. It is frequent to find interrelations in the cost. The importance of avoiding arbitrary allocations has already been emphasized. When abandoning is decided, the contribution is a much better criterion than that of gross or net profit (or loss). For example, by eliminating line A (Figure I) you would not save 250 thousand, because the general expenses would have to be reallocated to the other lines. Occasionally, even the contribution cannot be calculated in a determined manner. It is the case of linked products - where the increase of one provokes the increase o the other (for example, steel and slag). Fortunately the additional cost is rarely necessary, considering that there is no other choice, unless producing both.
The interpretation of should also be influenced strategic condition; if one "yesterday's sure profit" or a profit".
financial criteria by a particular product is the "tomorrow's sure
The vital cycle of a product is the most important concept to reason within this strategic dimension. The crucial implications of this concept are as follow.
(1) Products have a limited life span they pass through introductory phase, growing phase and eventually degenerate or disappear.
(2) The contribution to the profit tends to follow a forecasting course during the vital cycle. As figure 4
shows, at the introductory phase, usually there are no profits.
(3) At each step, the products demand new different marketing programs.
Figure 4 Vital cycle of a product
They tend to increase significantly during the growing phase, stabilize and then decrease during the maturing phase and almost disappear at the declining phase. Administration should be prepared to deviate the relative sums and, the price, the advertisement, the improvement of the product; and other aspects of the whole market should be emphasized during the different phases of the vital cycle of the product. In special, the products in the introductory and growing phases should receive a substantial aid of publicity and sales with the objective of giving them a special position in the market. Recent studies have called the attention to the importance of obtaining a part of the market for growing products. The empirical research showed that products which occupy greater parts I the market, tend to have smaller costs and higher returns over the investment. These smaller costs are derived from the scale economy and from the "experience effect". The part of the market with strategic aims, nevertheless, means small profits and a negative turn over of the money, during the preliminary phases of the vital cycle. Within the stable products, this should be counterbalanced by mature products with restricted investment
necessities and small necessities of marketing and, therefore, a positive monetary turn over. Using these ideas the consulting board suggested that a company can evaluate the stability of its product using the matrix on Figure 5. Products which are within the high growing quadrants are "stars" or "tomorrow sure profit products". Figure 5 Analysis of products' portfolio
They demand substantial sources to maintain and to increase the part of the market and this should supplied once that these products eventually become "milking cows" or t "today's sure profit products" The ones characterize themselves by the hi margin due to the scale economies a restricted financial demands, because maturity of the market. The resources generated by the products partially finance the "star". So, in a stable portfolio the products shift themselves in time from the left the right on the matrix, whereas resources should shift in the opposite direction. "The dogs" on the low quadrant are typically the great hopes of the part which did not achieve its potential position and are, at the present, the ones with low profits. With a small part of the market in a mature or in a declining market, there are small chances of them being good contributors. Finally, you have the "problem child" products with a small part of the market, but operating in promising markets. They are in competitive disadvantage with the leaders of the market, and they will become contributors if something is done, implying the associated risks to a violent marketing and the
investments on the product. Companies cannot cope with too many "problem child". A stable portfolio of products is the one that does not have all of its scaled products directed to one specific quadrant. The left side of the matrix is the one the one that represents its involvement with the future, the right side represents its involvement with the present profits.
WHAT SHOULD BE DONE?
The audit of the marketing yield, which concentrates on supplying calculations of the contribution of the products, isolate those which are the origin of deficiency. These should then be examined, tolerating the strategic considerations described above. We can illustrate this procedure, discussing results of the mentioned company. (Bidding 1) Line A was in a declining market, characterized by a tough price dispute. Among the tem products in line, five gave negative
contributions, there gave some marginal profit and only two generated a rate of contribution superior to ten percent. Even when eliminating the aid of marketing, this line was considered to be a dangerous drain of the company's re sources, on the long run; even when the two positive products did not have much of a promising future. Therefore, line A was totally discarded. Thirty percent of the products of line B and twenty percent of those of line C were totally eliminated. The products were consequently reduced from 32 to 17. In the past, publicity and promotion sales had been allocated proportionally to the turn over of the lines in the precedent fiscal year. This would strangle the potential of line C and, specially, that of line D - good lines in extremely growing markets. The financial turn over of line B was increased by suppression of the greater part of the publicity aid and by allocating more of the resources for lines C and D with a high potential.
Other modifications in market as a whole, include some price increases on the less profitable products, specially where there a great number of small buyers. Other than that, efforts were made to transfer the buyers of small variations to greater "regular" products, with the intention of giving to the first, the chance of being eventually eliminated. Finally, as a part of a more aggressive strategy for line 0, the prices were reduced, and these price cuts were violently promoted and sustained by a substantial sales campaign. Only one year after these decisions were taken, the company already demonstrated incredible raises on the turn over and on the profits. Considering these financial and strategic criteria, not undertaking a systematic revision of the portfolio of products delay the research of new products and create an asymmetrical set of others and a bad drain of the company's resources. The no operation reduces present profits and weakens the future bases of the company.
The company should be orientated for future demands, not only by leaving the obsolete lines behind but also by adding new ones. Inflation and variations of the market mean that the administration should accept permanent modifications and developments as a prerequisite for survival. This is the rational of the market focus which as: "since the intention of the company was to create a consumer, business has two and only two basic functions: marketing and innovation". When evaluating the opportunities of the new products the first task is to establish clear criteria for selection. Some evaluation for profit is an obvious parameter for a commercial company. The common evaluation is the increase of financial flow plus the total additional income generated by the life span of a product, minus the global expenses to produce it. Different opportunities can be scaled based on this evaluation for the profit. In few cases, where no alternatives are available, any contribution will justify the additional product.
On the cases of restricted capacity, the contribution per hour of equipment will be the criterion of staggering, for the great additions of products; however, the restricting factors is the use of capital. In this case, the return over the investment is the best evaluation. This form of profit evaluates the income, taking the efficiency of the product in relation to other uses. Bidding II
In a company which has diversified products, the number of factors complicates the problem of the selection of new products. First of all, the administration has objectives other than the profit; mainly, it aims at mains maintaining a constant growth of the incomes. They will be willing to sacrifice investments with a greater level of income, in exchange for projects which will stabilize more the total incomes of the company, as time goes by. Secondly, the administration tends not to take a chance and it's more inclined to projects with greater guarantee of income. Finally it's necessary to examine how a new product affects the potential profit of the other products of the line. Interactions are common; the greatest profit of addition should forgive losses and gains generated amongst the existing products. These problems are rapidly discussed in the following section. Generally, a new product will be an "improvement" of a product already in line. If the company has a big share of the market this
means that a good part of the added product represents "cannibalized" business of one the products is progress. Consequently, on the examining phase, it is crucial to evaluate the effect of the lose through substitution, when calculating the greatest profit expected with the new product. Where in it is supposed that a new brand would "cannibalize" the existing ones, it is expected that the director of brands achieves a higher gross margin than in the "cannibalized" business. However, in general, the companies have very little choice, because if they do not innovate the competitors will. Losing part of the market in the last situation, will certainly overcome the danger of "cannibalizing". Sometimes the new products are complements of the existing lines, and the perspective yield will be underestimated, underestimated, unless its effects over the incomes of the existing products were added. For example, a new brand should be violently promoted making possible that the existing products of the lines sell better.
The interaction of the costs exists when the new product affects the cost of the existing lines. Such interactions are normal once that the new product inevitably uses some of the same installations and the general administrative expenses. Considering that the accounting practice is to allocate all the cost, the margin of profit of the existing products will fatally be affected, even when the demands are independent. If the excessive capacity exists, the net profits of the present products will increase; when the capacity is being added, the present products will feel the effect negatively. If accounting conventionalizes and is able to deceive the administration, such effects of the costs should be eliminated with all the additional changes of the differences of the costs debited to the new products. Other than the profit, the administration, in general, will worry about the impact of a new product over the stability of the sales of the company. The usual objectives include an increase of the income and the desire to prevent the
economical and social costs of great peaks and depression on the occupational capacity. This objective demands a stable portfolio of products once that product in decline or slow growth are shifted away by new growing lines; and products within a set have different cyclic and seasonal peaks and depressions. The companies which have not forgiven the impact of the products over the variance of the sales, have subsequently found themselves committed by the excessive vitality of the sales. A new product will increase the magnitude of the global fluctuations of the sales if its standard coincides with that of the already existing lines. It will reduce the fluctuations if it expresses a measured growth or fluctuations in opposite phases. Adapting a set of products aiming stable sales constitutes one more restriction to the selection of products. Usually, a small amount of the increase of the sales is sacrificed in order to satisfy this restriction. The useful function of the administration will describe its interchange between of the sales and stability.
At the same time, considering the great fluctuations increase excessively the costs, it is not always true that the product, of which is expected a greater increase of sales, is the most profitable. The economy is more than ever subjected to faster and generalized modifications. These modifications mean that the companies are to be apt to fast adaptations within their lines of products. The administration needs a planning system to detain the necessary information to identify the problems of the set of products, the counting of the opportunities that appear in the market and to the analysis of the different strategies and controls. The problems can generally be identified by a regular supply of data about the contribution to the profit of the products in line. However, the decisions of marketing demand a detailed analysis of these problems to review the interactions amongst the products, the potential of the products on the long run, and the degree of risk that the company is willing to invest