Thursday, April 19, 2007

Tearing Down the House

Bob and Joe each had a house they wanted to sell. Bob was a little bit concerned about the condition of his house. His house had a couple of leaky pipes. Bob’s solution to the leaky pipe problem was to tear down the whole house and build a new one in its place. Bob was very careful about supervising the construction of the plumbing. After all, he did not want to repeat the leaky pipe problem. However, he was so focused on the plumbing, he failed to notice that the electricians put in faulty wiring. The faulty wiring would leave you in the dark at night.

Joe had a couple of problems with his house, too. But instead of replacing the house, he brought in a repairman to fix the problems. Then Joe did some research on home values. He discovered that there are certain key areas where one can spend just a little bit of money and get a dramatically higher resale price. So Joe spent a little bit of money on landscaping the front yard (increasing the “curb appeal”) and a little money to upgrade the master bathroom.

When it came time to sell the houses, Bob was in a bind. He couldn’t find anyone who wanted to buy the house he just built for what it cost him to build it. Part of the reason was because of the faulty electricity. Part of the reason was that if someone wanted a brand new house, they would prefer to design the home themselves. He took a big loss on the sale.

Joe made out much better. Because his house had been around awhile, Joe had built up considerable equity in the property. In addition, property values had risen over that time. The improvements Joe made increased the value of the house at a much higher rate than what the improvements cost. Joe made a good profit on the sale of his house.

Businesses can often be like old houses. They aren’t perfect; they have a few flaws that have crept in over time. Sometimes, leadership will look at these flaws and see the business as “broken.” To fix the business, they essentially tear it down and start over again. This could include actions like:

• Eliminating key members of management
• Getting a New Ad Agency
• Throwing away the old strategy and designing a new one
• Going after new customers
• Selling off lines of business
• Changing the core business model
• Etc.

This type of response would be similar to the actions Bob took on his house. He saw some problems and decided he needed to replace the whole house. This drastic response by Bob did not solve his problem. It only created other problems. The same can be true when companies see a problem and decide to revamp everything. Some examples of problems which this could cause include the following:

• By eliminating too many people, a lot of the intellectual capital of the company could be lost, leaving you in the dark on how to run parts of the business. They might go to competitors and use the knowledge against you.

• Too many changes to marketing and positioning can confuse the public as to what you stand for, and you end up standing for nothing.
Even though there may have been problems with the strategy and the old business model, there is no guarantee that the new model won’t have equal or worse problems of its own. It is untested for your business.

• All of these changes can be very expensive and may not prove to have a positive return on investment.

Conversely, Joe took a different approach to his situation. He fixed the problems he could see. Also, instead of tearing down the house, he prudently improved the house in ways that had a good return on investment. As a result he made out just fine.

The business analogy to what Joe did would be to stick with who you are and what your strategy is and just do two things:

• Repair the obvious blunders.

• Invest in activities which enhance the current strategy in a cost effective manner.

This process minimizes confusion in the marketplace and in fact may help strengthen one’s position in the consumer’s mind. Intellectual capital remains, and you do not place a lot of new unknown variables into the mix which would increase risk.

Too often in business, I have seen people eager to take out the axe and try to chop down much of what the business stood for and start over. This is particularly true when new management comes in. The heritage from the old regime is eliminated to make room for the entirely new vision of the new management. Often times, the better approach is to be like Joe—fix up a few problems and then build upon the old foundation to make it even better.

The principle here is the mathematical concept of compounded leverage. The idea, in simple terms, is this: A few small changes to the metrics in one’s income statement and balance sheet can make a huge improvement to the bottom line. There are three primary reasons why this is true. First, in most businesses, net income as a percent of sales is much smaller than many other lines on the income statement. Therefore, a small improvement to a large line in the middle of the income statement creates a proportionately larger percentage improvement to the smaller net income line.

Allow me to illustrate with an example. JC Penney and Kohl’s recently released their 2006 annual reports. At JC Penney, the year over year increase in gross profit percent (before expenses) increased from 38.3% to 39.3%, an increase of 1 full percent (or 100 basis points). Because most of their costs remained similar as a percent of sales, the improvement in gross profits fell to the bottom line, where net operating income grew from 8.7% to 9.7% (the same 100 basis point improvement).

However, because the Gross Profit line is so much larger than the Net Operating Profit line, it only took a small improvement at the top to get a huge improvement at the bottom. For example, at JC Penney, to get from a gross profit of 38.3% to 39.3% requires an improvement of only 2.6%. This little change at the top, however, caused the net operating percentage to increase by 11.5%.

A similar situation occurred at Kohl’s Department Stores. Their 2006 gross profit was 36.4% versus 35.5% in 2005, an increase of 90 basis points. Because Kohl’s made some slight improvements in expenses as well, net operating income increased 110 basis points, from 10.6% to 11.7%. In the case of Kohl’s, a 2.3% improvement to gross margin combined with a 1.1% improvement in operating costs (as a percent of sales) created a 10.5% improvement in net income (as a % of sales).

The second reason why small changes at the top can make bigger changes at the bottom is because multiple changes at the top can have a compounding impact upon each other. For example, if you can improve both gross margin as a % of Sales, as well as increase sales, the two work together to make gross margin dollars much larger than if only one of the two factors (sales or gross margin %) was improved. In essence, you have made a larger percentage slice of a larger pie.

In the case of Kohl’s we saw that gross profit as a % of sales increased 2.3%. What I failed to mention earlier was that at the same time, sales for 2006 at Kohl’s increased by 16%. As a result of the compounding of these two factors, Kohl’s gross margin $ increased by 18.7% and the operating margin $ increased by 28.2%. So, as you can see, a combination of smaller improvements at the top can multiply the benefits at the bottom.

The third reason why small changes can have a big benefit is because some tactical improvements impact multiple lines. For example, if a retailer found a way to run its business using slightly less inventory, it could gain improvements on many lines in its income statement, balance sheet, and cash flow, including:

• Lower operating costs at the store and the distribution center due to processing less inventory.

• Fewer reductions to gross profits caused by large price markdowns to get rid of excess inventory, since you now have less excess inventory.

• Less working capital tied up in inventory (potentially reducing debt and interest)

• Better sales from having fresher merchandise on the sales floor (due to increased inventory turnover).

As a result, the small improvement to inventory could end up having a huge impact on free cash flow due to its ability to impact multiple lines and compound the benefit.

Therefore, it is not always necessary to abandon a strategy and start from scratch in order to make significant improvements. Sometimes all it takes is renewed efforts around a handful of small improvements to the current strategy. This approach is often far less risky and usually requires less time and money to create the positive impact.

Not all problems require the abandonment of the strategic path one is on. Often, great improvements can come by just focusing on a few key initiatives which modestly improve a few metrics while reinforcing the current strategy.

Albert Einstein allegedly said that “the greatest force in the universe is compound interest.” The compounding of small improvements throughout the income statement, balance sheet and cash flow can have a similar type of power.

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