Business Transformation has to mean "stop doing the things the company does badly and loses money on"

Business Transformation has to mean "stop doing the things the company does badly and loses money on"

'Business Transformation' is a current buzzword not thought through carefully by many who use the term. If this is to be more than just internal cost cutting and wishful top line improvements, it has to mean "stop doing the things the company does badly and loses money on," writes Malcolm Newbery.

Re-cap of benchmarks and cost cuts

The first two articles in this mini-series were about benchmarks and cost cuts: who does them, why and how. They were based on an imaginary, but very realistic and "now" fashion brand, retail and e-commerce business which was composed of three divisions:

  • Selling wholesale to 400 stockist accounts across the world;
  • Operating as a retailer in UK, Asia and US from 100 physical stores;
  • Selling on its own e-commerce website to around 100,000 customers generating 10% (and a growing %) of physical retail sales.

It was performing poorly against its own budget and reasonable industry benchmarks. No action was no longer an option. Cost cuts were either being considered or actually put into effect in the following areas: Cost of sales, the prices paid to suppliers for the merchandise purchased, retail staff costs, warehouse costs, head office staff costs.

All of these cost cuts effectively left the business unchanged in what it did; they were just attempts to do the same things a bit better.

Incremental improvements, where to look for them and what they might achieve

The sales-based benchmarks give opportunities for positive improvements. The cost-based benchmarks provide excuses for negative destruction of business resources (i.e. costs). Both of these improve on the business current budget for autumn/winter and spring/summer which sum to an annual budget to end July. It is shown as Table 1 below:

Autumn/winter – Budget (GBPm)Spring/summer – Budget (GBPm)Yearly – Budget (GBPm)
Sales at full price, retail52.0048.00100.00
Sales at wholesale prices3.202.806.00
Sales through retail e-commerce5.005.0010.00
Total sales at full price60.2055.80116.00
Sales excluding VAT50.1746.5096.67
Markdown losses2.512.334.83
Net sales after markdowns47.6644.1891.83
Cost of sales (purchases)18.7617.3336.09
Achieved gross margin28.9026.8555.74
Overhead costs
>> Retail space cost8.108.1516.25
>> Retail staff cost12.4012.1024.50
>> Head office staff cost4.854.859.70
>> Head office other costs2.402.404.80
Total overhead costs27.7527.5055.25
Operating profit before interest and tax1.15-0.650.50

Retail sales from our 100 shops are GBP100m, wholesale sales to our 400 wholesale stockists are GBP6m, and e-commerce sales to our 100,000 direct consumer customers are GBP10m, totalling GBP116m.

Markdown losses are GBP4.83m, and cost of sales GBP36.09m, leaving an achieved gross margin of GBP55.74m, which is a gross margin of 57.7%

The various overhead costs sum to GBP55.25m, leaving an operating profit before interest and taxes of GBP0.50m, which itself conceals an operating loss in the weaker spring/summer season. Obviously this is not acceptable, and the raft of measures explained below are being considered to be put into implementation.

The sales based positive potential results are shown in Table 2:

1% improved sales density (GBPm)2% improved e-commerce prices (GBPm)2% improved wholesale prices (GBPm)
Sales at full price, retail101.00101.00101.00
Sales at wholesale prices6.006.006.12
Sales through retail e-commerce10.0010.2010.20
Total sales at full price117.00117.20117.32
Sales excluding VAT97.5097.6797.77
Markdown losses4.834.834.83
Net sales after markdowns92.6792.8392.93
Cost of sales (purchases)36.4436.5136.55
Achieved gross margin56.2356.3256.38
Overhead costs
>> Retail space cost16.2516.2516.25
>> Retail staff cost24.5024.5024.50
>> Head office staff cost9.709.709.70
>> Head office other costs4.804.804.80
Total overhead costs55.2555.2555.25
Operating profit before interest and tax0.981.071.13

Sales density is to be improved by just 1%, a modest target that will generate an extra GBP1m on physical store sales. Naturally the cost of sales rises (the extra merchandise sold has to be bought), but overheads are unaffected. The operating profit would potentially rise from GBP0.50m to GBP0.98m.

E-commerce prices are to be increased by 2%, theoretically to cover delivery costs. Sales would rise by GBP0.20m to GBP10.20m, and the operating profit would potentially rise from GBP0.98m to GBP1.07m, but only as long as all e-commerce customers continued to buy as before.

Wholesale prices are also to be increased by 2%. Sales would rise by GBP0.12m to GBP6.12m, and the operating profit would potentially rise from GBP1.07m to GBP1.13m, but only as long as all wholesale customers continued to buy as before.

Both the margin based positive potential results and the negative based markdown costs are shown in Table 3 below:

2% improved markdown loss (GBPm)2% improved gross margins (GBPm)
Sales at full price, retail101.00101.00
Sales at wholesale prices6.126.12
Sales through retail e-commerce10.2010.20
Total sales at full price117.32117.32
Sales excluding VAT97.7797.77
Markdown losses4.744.74
Net sales after markdowns93.0393.03
Cost of sales (purchases)36.5535.42
Achieved gross margin56.4857.61
Overhead costs
>> Retail space cost16.2516.25
>> Retail staff cost24.5024.50
>> Head office staff cost9.709.70
>> Head office other costs4.804.80
Total overhead costs55.2555.25
Operating profit before interest and tax1.232.36

Markdown loss is reduced. Nobody knows by what methods. The operating profit would potentially rise from GBP1.13m to GBP1.23m.

Gross margins are improved by cutting merchandise quality. Nobody knows whether the customers will still buy. The operating profit would potentially rise from GBP1.23m to GBP2.36m.

Overhead cost cuts are shown in Table 4:

1% improved retail staff costs (GBPm)2% improved head office costs (GBPm)2% improved costs at warehouse (GBPm)
Sales at full price, retail101.00101.00101.00
Sales at wholesale prices6.126.126.12
Sales through retail ecommerce10.2010.2010.20
Total sales at full price117.32117.32117.32
Sales excluding VAT97.7797.7797.77
Markdown losses4.744.744.74
Net sales after markdowns93.0393.0393.03
Cost of sales (purchases)35.4235.4235.42
Achieved gross margin57.6157.6157.61
Overhead costs
>> Retail space cost16.2516.2516.25
>> Retail staff cost24.2624.2624.26
>> Head office staff cost9.709.519.51
>> Head office other costs4.804.804.70
Total overhead costs55.0154.8154.72
Operating profit before interest and tax2.602.802.89

Retail staff costs are trimmed by just 1% from GBP24.50m to GBP24.26m. The operating profit would potentially rise from GBP2.36m to GBP2.60m.

Head office staff costs are trimmed by just 2% from GBP9.70m to GBP9.51m. The operating profit would potentially rise from GBP2.60m to GBP2.80m.

Warehouse costs are trimmed by 2% from GBP4.80m to GBP4.70m. Nobody knows by what method. The operating profit would potentially rise from GBP2.80m to GBP2.89m.

Top management look at all of those hopeful improvements (many of them unsubstantiated and on dubious bases) and decide that incremental improvements (the "last time but a bit better" method) is not feasible.

Business Transformation

So, they decide to go for 'Business Transformation,' a recent buzzword not thought through carefully by many who use the term. If this is to be more than just hopeful top line improvements, and internal cost cutting, it has to mean "stop doing the things the company does badly and loses money on."

In this article, I can only hazard a guess on what the areas might be that are "ripe" for Business Transformation. I am suggesting that it is unlikely to include the e-commerce function, because it is growing. The top management brainstorm six areas that are ripe for transformation. They are

  • Withdraw from poor performing wholesale regions, and hope that e-commerce will fill part of the gap;
  • Withdraw from loss making retail territories, and hope that e-commerce will fill part of the gap;
  • De-layer a bloated UK retail staff;
  • Withdraw from expensive long distance e-commerce delivery activities;
  • Cut warehouse costs by sacrificing delivery speed for reliability;
  • Reduce product quality to improve gross intake margins.

Some of these ideas are similar to the small incremental improvements in benchmarks. But they are now grounded in facts and activities, not in hopes. Management decide to reject two of the six ideas:

  • Number 4, because they see the future as e-commerce;
  • Number 6, because they think the customer will not tolerate it.

No company function is safe, but this approach changes the thrust from a functional review of cost areas, to a holistic view of the company as a series of discrete businesses. It can therefore only be undertaken by a taskforce that works across functions, and is top-down driven. The changes will lead not to incremental improvements, but to specific improvements caused by individual management decisions and actions.

Business Transformation changes and re-budgeting

#1: Withdraw from poor performing wholesale regions, and hope that e-commerce will fill part of the gap
The wholesale business in Europe will go. 160 accounts (40% of the total) lose the company GBP2.40m in sales and GBP0.48m in gross margin (at 20%). But there are savings in overhead costs:

  • Agents cost 12.5% in commission, a cost reduction of GBP0.30m;
  • Four order-taking clerks are saved at head office, a saving of GBP0.10m;
  • Five warehouse staff are saved, a saving of GBP0.10m;
  • Wholesale transport to Europe is eliminated, a saving of GBP0.23m.

Altogether the business transformation saves GBP0.73m against lost margin of GBP0.48m.

And if just 50% of the consumer customers convert to e-commerce at retail prices (instead of buying from wholesale retail customers), there will be extra margin of approximately GBP5.00m, after deducting extra e-commerce delivery costs. It's a winner.

#2: Withdraw from loss-making retail territories, and hope that e-commerce will fill part of the gap
The retail stores business in America will go. 15 shops (15% of the total) lose the company GBP15.00m in sales and GBP8.00m in gross margin (at 65%).

But the costs of shop staff in America and a regional director are GBP3.68m. High city rents will be saved of around GBP3.25m (admittedly in the long term).

If 50% of our consumers still buy off our website, it will recoup GBP7.50m in sales, and GBP4.00 in gross margin – but at an unknown fulfilment cost, on which we have done a rough calculation of GBP0.50 Nevertheless, it looks at least like a smaller winner. It is also what Boohoo is doing to its Karen Millen acquisition in the UK.

#3: De-layer a bloated UK retail staff
There are 60 UK shops, each with an average of 8 staff, costing GBP14m or GBP30,000 each person per year. By de-layering, the plan is to save 10% (GBP1.40m), but at an unknown customer service threat.

#4: Cut warehouse costs by sacrificing delivery speed for reliability
We currently deliver to the shops weekly. That will continue. We try to deliver to e-commerce customers within 24 hours. That will be changed to 48 hours. It might save 5% of total warehouse costs, as the warehouse is no longer servicing European wholesale, or American retail. That figure is a total of GBP4.70m, so a saving of GBP0.23m

Table 5 puts these forecast gains and losses together under four headings: Lost margin, New margin, Regained margin and Cost savings.

Lost marginNew marginRegained marginCost savingsTotal
1. Exit European wholesale-£0.48=+£5.00=+£0.73=+£5.25
2. Close US retail stores-£8.00=+£3.50=+£6.93=+£2.43
3. De-layer UK retail staff£1.40=+£1.40
5. Cut warehouse staff costs=+£0.23=+£0.23
Total of all transformation changes=+£9.31

Business transformation has cost us top line sales of GBP8.70m, but a transformation profit of GBP9.31m. The money gained from the warehouse cost cuts is so minimal that the company decides not to risk the customer dissatisfaction. So the agreed plan is to bring in just over GBP9m. Seeing as we were making almost nothing before, an operating profit of GBP9m on reduced sales of GBP108.00m is a enticing prospect. But it still has to be implemented. So, let's get on with business transformation.

Click on the following links to read the first two articles in this mini-series: