Managers-Net

Simple systems corrupted by growth

In the early days of mobile phones, an inveterate entrepreneur saw an opportunity to ride on the wave of insatiable demand. He set up a business to buy phones from manufacturers and sell them in large quantities to large retailers. That was the 'business system' - few businesses could be simpler. It grew rapidly, and he made a lot of money. The large yacht moored in Monaco the outward sign of financial success.

But day by day, with growth, came sub systems, all seen as 'quite normal' and required to support growth. Instead of pallets of product being shipped direct from manufacturer direct to the end customer, stock was needed. This set in train the need for Buying, Inbound Logistics and Warehousing. Instead of a handful of large customers, the types and numbers of customers proliferated. This set in train a need for Selling, Credit Control, Order Entry, Order Fulfilment and Outbound Logistics.

The underlying 'Basic System' of Buy, Sell, Deliver, Collect the Cash had not changed. If the selling price minus the purchase price (the gross margin) was greater than the cost of being in business, then the business was profitable. The entrepreneur had done extremely well with this mantra and used the gross margin measure as his main yardstick of how well the business was doing. In the early days the gross margin provided funding for growth.

But as the numbers of employees grew, so did a natural split of people into similar groups of expertise. We recognise these as functions, headed by a functional director and hierarchies of management. Within each function, sub systems grew in complexity and the interactions between functions, which we would call the business processes, became foggy as people lost visibility of the impact their work had on others. Measures of functional success and a desire to motivate through various bonuses exacerbated the increasing but hidden underlying problems. But at this stage in the growth cycle all this remained invisible to the CEO and each Functional Director. After all, each was doing well by the criteria set by the CEO. The company grew, the CEO was always smiling.

Buoyed up by this apparent success, the CEO decided to leapfrog organic growth and make a massive leap to expand from his traditional customer base and so set the company on a new path to capture the burgeoning growth in sales outlets. He was determined to be the supplier of choice to all the small retail phone shops that were springing up in every town. The expansion was funded by going PLC, raising capital from institutional investors who had 51% of the business, the CEO the rest of the shares. A massive warehouse was acquired, new multilevel offices found and populated with ever more staff. On one floor, the finance department filled up with credit control staff, as the expanding customer base of small shops were developing some worrying trends, and on another floor the sales staff were growing in number, proactively bringing new customers on stream then taking ever more volumes of orders. Whoops of excitement could be heard regularly across the sales floor as new customers and new orders came flooding in. The CEO had issued a calculation sheet to each salesperson so they could calculate the gross margin of each order as it came in and immediately see the bonus they would get as a percentage of gross margin. From the CEO's office he could view the growing signs of success. His employees loved him.

But then a few dark clouds appeared on the horizon. He could not reconcile the signals he was getting. On the one hand the warehouse was full of phones that the Purchasing Director had successfully negotiated prices for at very competitive discounts. His bonuses based on these discounts had worked. The Sales Director was purring with contentment. His bonus was based on the overall gross margin of all UK sales. All he had to do was push his people to go for sales volume. Any other measures had no bearing on his bonus. In the search for more volume the Sales Director came up with a proposal to the CEO to get greater lock-in of their customers (the retailers} and be able to offer to potential customers. Instead of insisting that customers made weekly orders, the industry 'norm' at the time, they made a pledge to provide next-day deliveries. Order by 6pm for delivery the next day. It worked. A steep rise in number of orders and total phones sold ensued. Sales bonuses burgeoned.

On the other hand, storm clouds gathered, and the sky darkened when the sales got to £250m and he began making a loss of £1.5m per month. There was a weird correlation. As sales volumes increased so profitability plummeted. Its share price followed. A tumble to 3% of its highest level. Shareholders became highly concerned. It looked like the yacht would have to be sold. Within the simple Business System there lurked some causation factors which meant that growth led to losing money despite all the 'normal' measures indicating success.

Now here is the rub. If such a simple Business System can go so unpredictably awry, how easy must it be for bigger and more complicated businesses to lose their way. And while everyone in a business may feel they are doing the right things, and mostly in the right way, and being rewarded for it, nevertheless the course can be set for failure and sometimes it is too late to make a recovery.

This business was not unique. Neither were the causes of its downfall common to all businesses. However, in my experience of applying Systems Thinking to get to grips with what is really making things happen, there are a few ways of looking at businesses, their processes, their measures and the basis of reward mechanisms that can give early warnings of trouble and thus a chance to turn things around.

The root causes in this particular business are worth noting. They may be worth remembering in your own career.

Analysis - first main root cause

Mobile phones are expensive items so you should have good cause to stock a lot of them. They are an asset on the books for as long as at the point of sale the sales price is greater than the purchase price. In other words, as long as there is still a gross margin to be made. You will recall that the Purchasing Director was bonused on how well he could negotiate discounts: the logic being that this was the initial competitive advantage the company could gain. He did well. He counted several major manufacturers among his friends. He boasted they would even ring him up to give him exclusive 'first bites' on buying bulk of certain models. The pity was that on scrutinising the history of his deals, manufacturers were essentially dumping older models prior to launching ones that would supersede them. A walk around any warehouse running your finger across the top of pallets can give you a clue as to how much dust has gathered. In this case the figures were more damning. While struggling for stock on very popular lines, far too much stock of predictable demand was being held. An analytical approach would have applied proper algorithms. But the real issue was that 40% of stock was in the two months to a year category of turnover. Coupled to the fickle nature of demand for phones, it was clear that consumers wanted the latest versions. After two months, phones could not be sold to the retailers for more than their purchase price from the manufacturers. When nearly half your stock suffers a negative gross margin, you have a problem. No wonder, in this case, that salespersons were reluctant to try and sell these phones as it meant no bonus for them. The bulk of these phones went to third world countries desperate to get their hands on any phones.

So, in summary, this root cause was not exposed as its existence did not impact on reducing the Purchasing Director's bonus nor that of the Sales Director. In contrast, a Systems Thinker would have spotted this as an issue that would cause major problems later on.

Analysis - second main root cause

To become a 'Systems Thinker' the first thing to note is that however simple the Business System seems to appear at first sight, a walk through the key processes quickly uncovers the anomalies. This kind of helicopter view of the processes is generally not enjoyed by the people working in the processes so cause and effect (of problems) remains invisible. Where a culture of functional parochialism exists then any curiosity on behalf of staff to look upstream or downstream in the process is often actively discouraged. Unencumbered by such distractions the systems thinker looks at the process. So, what did this reveal at this company?

The receipt of orders kicked off the main process, so it made sense to look at the order profiles. A very few customers ordered around 2,000 products at a time - whole pallets. At the other extreme, 20% of customers were ordering one phone at a time. About 50% of the customers ordered four or fewer units per order. These orders only added the last 5% of sales value and gross margin. It raised the immediate question; will the last 5% of gross margin be sufficient to cover the cost of processing the small volume orders? If the gross margin in such orders did not cover the cost of processing the order, then that order lost money. Now the key focus of the systems thinker turned to this vital piece of analysis.

The process walk uncovered an interesting relationship in that the overriding cost driver in the business was the number of orders. Almost irrespective of the size of the order, each order drove much the same set of activities such as 'order entry', then 'credit check', then 'pick & pack', then 'dispatch', then 'invoicing'. So, for any orders where the gross margin was less than the order processing costs, those orders made a loss. Suddenly the key issue dawned on everyone - far from believing that a positive gross margin was always good because it was contributing to overheads, if the real net profit was negative then more volume meant ever-increasing losses!

Resolving two questions

• Were there particular customers who were placing orders which just lost them money every time?
• Why when volumes were increasing did growth seem to lead to declining overall profitability?

The analysis looked at the characteristics of various customer segments. One segment, small High Street Dealers, accounted for 50% of sales value, ordering 87% of the total volume, mostly as small quantities of phones per order with an average order gross margin of only £15. For the whole company, the analysis had shown that the average cost to process an order was around £50 which meant that for the High Street Dealer segment, on average each order lost the company £35. These customers were the source of the falling profitability of the business as overall volumes and number of customers increased. The company's apparent successful growth had really been in ever increasing unprofitable business actively encouraged by the volume growth strategy and the very generous customer service policy. The High Street Dealers simply de-stocked down to one day's worth of sales knowing they could get next day delivery without paying a premium price. By setting the minimum order value such that the gross margin was always greater than £50 ensured no unprofitable orders were taken. Most customers complied with the new minimum order values. Those that threatened to take their business to competitors were encouraged to do so. The competitors would welcome the business but unwittingly would be taking on a significant loss.

It was now very apparent that the policy of paying the sales force a bonus based on gross margin had encouraged the sales force to drive the business into the ground. Salespeople did not realise that their decisions contributed to keeping the warehouse half full of unnecessary aging stock or that order processing costs outweighed the gross margins on the majority of orders. But they had no reason to suspect there was a problem. And in any case, if the net profit was negative but the gross margin positive, they still got their bonus.

Benefits of taking a 'Systems Thinking' view

The key lesson for this company was the ease by which they were blinded by apparent success. The founder and CEO of the business realised that the money he had raised by going plc had mostly gone into growing the physical size of the company to service unprofitable business.

Initially the City had measured success in sales volume terms. Also share prices in the sector had rocketed for everyone so a true measure of performance was obscured for a considerable time. The salesforce was generating positive gross margins and collecting bonuses, so they were not complaining. No signals came from the Sales Director of the impending problems.

When companies are growing it should be a business imperative to retain a System Thinking view of the business and have the tools and techniques of analysis to determine the real net margins of products and customers. This will ensure they avoid the pitfalls that can so easily turn the trend of apparent roaring success into a spiral of decline that is hard to slow down.

At the 11th hour the change in selling policy to a minimum order quantity ensured that the gross margin always covered the costs of processing the order and meant that profit was not haemorrhaging from the business. However, the change back to profitability came with a large reduction in total volume sales as customers who wanted to remain in an unprofitable relationship were simply turned away. Profitability came at the price of reduced volumes of orders to process which meant fewer people were needed, housed in less space and without the need for the huge warehouse. The inevitable downsizing was painful.

And the CEO? During the investigation, the CEO pushed out, or the Director resigned, as the issues in each function were revealed. The CEO was not a forgiving character. The System Thinking review of the business provided the route map to get back to profitability but with the share price at its lowest the company was vulnerable to a takeover. The CEO lost his business. Systems Thinking is serious. To ignore it is a business risk.