ABC plc Analysis of Profitability A Report Executive Summary

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ABC plc was founded in 2005 in Birmingham, UK for the manufacture and sale of small oil fired industrial boilers.

Whilst the company received a number of orders in the first two years after its inception, it has been struggling for the last 3 years. The organisational management initially attributed the slow growth in sales and rather poor profitability of the organisation to the slowdown in economic growth and industrial production because of the financial and economic crises.

This report has been prepared in response to the request of the Managing Director. It investigates the reasons for organisational underperformance and poor financial results and provides appropriate recommendations for improving financial performance.

Introduction

1.1. Overview

ABC plc was founded in 2005 in Birmingham, UK for the manufacture and sale of small oil fired industrial boilers. Promoted by Ken Grant and Richard Millet, both of whom work as directors for the company, ABC plc supplies its boilers to small and medium organisations across the UK. Whilst the company received a number of orders in the first two years after its inception, it has been struggling for the last 3 years. The organisational management initially attributed the slow growth in sales and rather poor profitability of the organisation to the slowdown in economic growth and industrial production because of the financial and economic crises. The senior management however now feels that there could be other organisational reasons behind the inadequate financial and operational performance of the company.

The management has also noticed that the quotations offered by the organisation for their products are often significantly higher than those tendered by their competitors. It is also noticed that the prices of firm orders received by the company appear to be inadequate for meeting the direct expenses and contributing to the overheads of the company.

1.2. Objective

Mr. Grant, the MD of the company has asked for an investigation into the reasons for such poor operational and financial performance. This report has been prepared in response to his request and attempts to investigate the financial reasons for organisational underperformance and for the continuance of poor financial results.

2. Issues and Problems

2. 1. Organisational Performance

The broad organisational performance of the company, in terms of sales, both in amount and in numbers and profitability are detailed in the table provided below.

Year

Unit

2005

Actual

2006

Actual

2007

Actual

2008

Actual

2009

Actual

2010

Expected

Sales

GBP 000

550

800

1100

1010

1025

1050

Sales

Numbers

36

45

55

50

54

57

Gross Profits

GBP 000

330

488

649

606

625

640

Gross Profits

%

60

61

59

60

61

61

Profits before Interest and Tax

GBP 000

138

216

297

181

125

(25)

Profits before Interest and Tax

%

25

27

27

18

15

13

It is evident from the figures on sales and profitability that whilst organisational performance improved steadily from 2005 to 2007, the situation changed significantly in subsequent years. Sales dipped somewhat in 2008. Its recovery since then has been rather slow and organisational sales in 2010 are expected to be marginally better than 2009.

There is cause for greater worry in the area of profitability. Available figures reveal that whilst gross profits have remained more or less constant in terms of percentage of sales, net profits have reduced sharply. The organisation is in fact expecting to incur losses in 2010. The sales department has been complaining that the company has repeatedly been losing out in getting orders from clients because their bids are significantly higher than those provided by their competitors.

The managers in charge of production and purchase however state that the prices of finalised orders are not adequate for satisfaction of the organisational costs that have to be incurred for purchase of materials and components, labour, subcontracting, and site erection. The opinions of the sales and production managers regarding prices of products are diametrically opposite. The sales manager states that quoted prices are higher than those offered by competitors whereas the production manager states that they are too low for satisfaction of necessary organisational costs.

Such differing perceptions between sales and production managers are leading to the emergence of internal conflicts that are intensifying because of poor organisational performance.

2.2. Preliminary Investigation

Preliminary investigations reveal that the present operational difficulties and poor financial performance arise from slowdown in growth of orders and reduction in proportion of net profits. An examination of administrative costs and other indirect overheads reveals that costs are being very tightly controlled and no undue increases have occurred in various areas like workforce expenses, power, and other manufacturing and subcontracting costs.

It was thus decided to commence the investigation with an analysis of the bidding process.

2.3. Mechanism of Pricing Process

An investigation of the pricing process reveals it to be a reasonably well coordinated process involving production, marketing and sales departments. The process begins with the release of an enquiry for a boiler by a specific client organisation. With the needs of most organisations being bespoke in nature, individual quotations are prepared with care for each specific bid. The enquiry is picked up from the client organisation by the sales department and forwarded to the marketing department. The marketing department provides the customer specifications to the production department, which then prepares the total material costs, both raw materials and bought out components, for the order and provides the details to the marketing department. The marketing department uses the estimates provided by the production department and adds a loading of 100% to arrive at the offer price. The offer price is then communicated to the sales department, which thereafter handles all communication with the client.

The chart provided below details the various steps involved in the bidding process.

Enquiry

Marketing of ABC plc

Sales of ABC plc

Client

Client

Production of ABC plc

Client

Offer Bid Price Information

The process is carried out in the greatest of confidence and both production and sales departments do not know the process whereby marketing fixes the final offer price. The marketing manager reports to the MD of the organisation and keeps the price fixation process confidential.

2.4. Analysis of Pricing Process

The existing pricing process for preparation of organisational bids was taken up for detailed investigation and analysis from financial perspectives.

It was revealed that the existing process was introduced by the marketing manager, who joined the organisation in 2007. The bids were previously prepared by the MD, who prepared each bid himself after investigating all associated costs in great detail. The marketing manager was recruited in 2007 to relieve the MD’s workload, which had progressively been increasing because of steady organisational growth. It was felt that the induction of a specialised marketing professional into the organisation would increase organisational decentralisation, free the MD from routine operational work and enable him to deal with important strategic matters, enhance the marketing abilities of the organisation, and improve its competitive edge.

The marketing manager, whilst experienced in industrial marketing does not have any experience in the marketing of customised industrial equipment. One of his first actions after joining concerned the rationalisation of the bidding process. Attempting to substantially increase the bidding and marketing efforts of the organisation, he felt that the bidding process adopted by the MD was too detailed and time consuming and would not allow the organisation to chase more sales opportunities. He thus drew upon his experience in his previous organisation and simplified the bidding process by asking the production department to determine the material costs and by thereafter loading the material costs with a factor of two to arrive at the offer price. The doubling of the material costs, he felt, would be enough to meet all other costs and ensure a handsome profit for the company on every executed order.

Whilst such a procedure for preparation of bid prices may be appropriate in certain circumstances, where both material costs and overheads are well known and standard in nature, the adoption of such a method of pricing of customised industrial products can have serious financial repercussions. The products of the company, namely small and medium sized industrial boilers, are manufactured to the specific demands and requirements of various buyers and often differ significantly in scope of supply. The organisation manufactures some of its components at its own premises. Some components on the other hand are outsourced to subcontractors. In such cases the material is either provided by ABC or by the subcontractors themselves. Apart from producing these items, the company purchases a number of components like pumps, motors and instrumentation directly from suppliers, which are then assembled into the final product. The organisation is also called upon to erect and commission the boilers after they are delivered to client locations. Such erection and commissioning, whenever it is in the scope of organisational activity, is a complex process that is not just time consuming and elaborate in nature, but also involves the deployment of erection supervisors and the use of erection contractors.

The manufacture of an industrial boiler is thus a complex and detailed process that involves (a) own manufacture and production, (b) production at subcontractors’ premises with own or subcontractors’ material, (c) purchase of components, (d) assembly, and (e) erection and commissioning. The complexity of the production process requires the use of a sophisticated and detailed financial process for the preparation of bids. Such preparation of bids requires careful analysis of (a) cost of raw materials, (b) cost of bought out components, (c) cost of subcontracted items, (d) cost of labour, both for manufacture and assembling, (e) cost of erection and commissioning activities and (f) costs of administrative, sales and marketing overheads.

The adoption of a simplistic bidding process can lead to absolutely skewed results and the preparation of bid prices that could (a) be too high and uncompetitive, or (b) too low and thus unprofitable. Orders with extremely high raw material requirements could lead to the formulation of very high bid prices and make the bid uncompetitive in comparison to those provided by competitors. Orders with low material requirements and higher costs of conversion or erection and commissioning could on the other hand lead to the formulation of unrealistically low bid prices.

Such a bidding process would be likely to lead to a situation where the organisation would receive firm orders, which were likely to be unprofitable, with low material requirements and high production and conversion costs. It would also obviously result in circumstances where the sales department would feel that bid prices were unnecessarily high, even as production managers would find that the prices of actual orders received were too low. These circumstances would in turn lead to loss of orders, drop in sales, receipt of unprofitable orders, and poor profitability.

3. Recommendations and Solutions

The examination of the current bidding process reveals it to be faulty and the main reason behind the poor financial performance of the company, as well as an important cause for lack of growth in sales.

ABC plc should immediately change its bidding process and ensure the detailed involvement of the finance department in formulation of bids. Enquiries for orders should henceforth be analysed with regard to cost of raw materials, cost of labour for manufacture and assembling, cost of subcontracting, cost of bought out components, cost of erection and commissioning, and cost of allocated administrative and other overheads. All these costs must be carefully elaborated to build up a total cost structure for each enquiry. The total estimated costs should thereafter be increased by the expected profit margin of the organisation to arrive at the final bid price.

The preparation of a bid must henceforth become a multidisciplinary function involving the efforts of the production, the marketing and the finance managers.

4. Impact of Solutions

The adoption of the new bidding process and its implementation for future orders will lead to the following results:

Increase in competitiveness of the organisation because of better formulation of bid prices.

Receipt of more orders with good prices

Elimination of unprofitable orders

Assured profitability on received orders.

It can be assumed that the implementation of these recommendations should lead to an increase in sales by 10 % in 2011 and the achievement of a Net Profit Ratio of 25 %.

The forecasted profitability for 2011 is indicated as under

Year

Unit

2005

Actual

2006

Actual

2007

Actual

2008

Actual

2009

Actual

2010

Expected

2011

Expected

Sales

GBP 000

550

800

1100

1010

1025

1050

1155

Sales

Numbers

36

45

55

50

54

57

62

Gross Profits

GBP 000

330

488

649

606

625

640

705

Gross Profits

%

60

61

59

60

61

61

61

Profits before Interest

and Tax

GBP 000

138

216

297

181

125

(25)

289

Profits before Interest and Tax

%

25

27

27

18

15

13

25

Adoption of these changes should result in a dramatic turnaround in organisational sales and profitability and establish the company on the road to growth and profitability

5. Conclusions

ABC plc is engaged in the manufacture and sale of small oil fired industrial boilers.

Whilst the company received a number of orders in the first two years after its inception, it has been struggling for the last 3 years and expects to record losses in 2010.

Investigations reveal that the present operational difficulties and poor financial performance arise from slowdown in growth of orders and reduction in proportion of net profits. The examination of the current bidding process reveals it to be faulty and the main reason behind the poor financial performance of the company, as well as an important cause for lack of growth in sales.

ABC plc should immediately change its bidding process, ensure the detailed involvement of the finance department in formulation of bids, and adopt the recommended bidding process. The adoption of the new bidding process and its implementation for all future orders should lead to significant improvement of operational and financial performance.

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