Lean As An Investment Thesis – Lean Principles

A couple of years ago we worked with a packaging company that had about $6 million in EBITDA. Initially, we projected that the company could increase EBITDA by about $1 million through the application of Lean principles. These opportunities weren’t hidden, just overlooked. There was a lot of work-in-process inventory. Some periods had high overtime, others excess capacity. Poor controls and a loose inventory strategy led to lots of frazzled customers, and the company compensated for these issues with expedited shipping.

By applying Lean principles, the company realized not $1 but $2 million in EBITDA improvements within 6 months. But here’s something that might surprise you: they also saw a 20% increase in capacity. In short, not only did existing business become more profitable, but the company could grow by 20% without adding additional capacity.

And those margins kept growing! Within a year, the management team actually realized $3 million in increased EBITDA and $1 million in reduced inventory. The company manufactured a 50% increase in EBITDA and built $30 million in market capitalization without increasing revenues.

Lean is a Philosophy

This is the difference between treating Lean principles like a one-time implementation plan, and the philosophy they truly are. Those new to the idea sometimes worry that adopting Lean principles will inhibit growth, but as you can see, that’s the furthest thing from the truth. In reality, waste often accounts for a substantial amount of your capacity, and reducing it puts time, money, and infrastructure back in the resources column. Transforming the culture of an organization around Lean principles yields very specific benefits, including increased scalability of operations, reduction in stagnant inventory, and a virtuous cycle of improvement.

Will Lean Impact Your Company?

When estimating the potential impact of implementing a Lean model, there are some key indicators we look for. The most obvious problems involve inventory. We’ve already mentioned work-in-process materials. Excess inventory is another classic marker. The flipside, of course, is back-orders. All of these issues indicate that operations are not balanced correctly with customer demand, which is a problem we can help you fix. Unusually high levels of scrap, rework, and warranty costs are further signs of waste that can be eliminated.

Another indicator we often see is a lack of metrics and post-mortems. In companies that don’t monitor key performance indicators, we typically find opportunities for at least 10-15% improvement, and productivity goes up when KPI’s are reviewed during the shift or work day. After all, the fastest way to identify and resolve a problem is to take a look at actionable metrics while the events of the day are still fresh in your mind.

Another thing we investigate is downtime. We measure companies against the theoretical maximum production their facility could produce, then track down the source of any discrepancies between capacity and actual output. That’s where you have room to transition from cost savings to growth opportunities.

Lean Applies to All Business Models

Many types of companies can apply Lean principles. Obviously, with manufacturing companies we look at WIP inventory that’s languishing. We identify under- or ineffective utilization of existing assets. We quantify the extent to which excess product is tying up capital before there’s actual demand.

But Lean is just as useful for other models. In healthcare, it can be applied to patient care issues, like registration and wait times. Lean can help reallocate resources to address actual patient population and flow. It can streamline revenue cycle management.

Distribution companies can benefit from Lean as well. On time, complete and accurate fulfillment of an order is the distributor’s equivalent of good production. When working with these companies, we focus on pick times and accuracy, slotting methodologies, and manning tables and controls.

With business services companies, we can apply Lean to the processes that directly create the value customers pay for, as well as supporting processes that involve documentation, invoicing, and collection.

Lean Improves Higher Business Functions

The truth is, any company can benefit from applying lean to its support and administrative functions, like accounting, supply and demand planning, and even forecasting. While these areas do not directly add value to customers, they do impact a company’s ability to maintain an environment in which you can add value to customers and get compensated appropriately.

The main thing to remember is that Lean is not something you implement and then walk away from. It’s a philosophy, one which needs to be socialized until it’s a company-wide practice with champions at all levels of management. Fully implemented, it means less hands-on monitoring for your organization’s top leadership, enabling them to be more vision-driven.

Applying lean to your portfolio company will pay for itself in the short term with EBITDA and working capital improvements. In the longer term it will also develop additional capacity and a virtuous cycle of improvement. Make Lean part of your investment thesis and drive it!

9 Boxes Full of Financial Improvement – The Case of Pricing

When a mid-market company is delivering great profits and cash flow, it’s probably human nature to think, “We’re doing great” and get a little too comfortable. Rose-colored glasses don’t reveal where performance is well below where it could be.

Even when there’s every incentive to find out why a company’s results aren’t so good, it’s still tough for management teams and boards to spot all the areas where results can be improved. Conventional financial and operating metrics just don’t go deep enough.

Both causes of fuzzy vision pose a big problem for incumbent owners and management teams, because very, very few companies are performing at their full capabilities.

For private equity groups, though, management’s fuzzy vision presents a great opportunity:

  • PEGs can develop better information during diligence and use that to advantage in their offer price.
  • Post-acquisition, they can implement the improvements highlighted during diligence and rapidly boost performance and enterprise value.

9-Box & Pricing

The ProAction Group’s 9-Box analysis is like having x-ray vision. It reveals the potential that lies beneath the surface to bump up EBITDA and lower the assets required on the balance sheet. It’s a powerful tool for PEGs that invest in manufacturers and distributors of standardized products.

In addition to showing where production and inventory management can be optimized, 9-Box analysis also indicates opportunities for pricing improvement.

Bob Sherlock of Marketwerks, a ProAction Group alliance partner, observes that “Management typically thinks that their prices are all right on the edge, about as high as they can be. They hesitate to take pricing action for fear that they’ll lose profitable volume. But every single company we’ve worked with was underpricing at least some of their products, for some customers, in some geographies and transaction types. The least risky pricing move in the world is to find where customers would willingly pay more, if you weren’t giving them the opportunity to pay less.”

“ProAction’s 9-Box analysis lets us see areas of underpricing, drawing inferences that we can validate in other ways,” Sherlock says. “The #1 factor in pricing is external—the prices at which enough customers will buy. But it’s also essential to understand prices at which the company should be willing to sell. The 9-Box process gives us insights into both of those.”

Case Study: Who is deciding pricing strategy?

9-Box Case Study

We have a real world case study of a 9-box analysis. Here are the actual conclusions:

Case Study Conclusions

  • Pricing, inventory and approach for “A” customers and “A” sku’s show that leadership understands where money is made. We got the important stuff right!
  • Pricing strategy seems focused on managing “A” customers well. B and C customers get preferential pricing today.
    • Increasing external customer margins to meet “A” Customer margins would increase B & C customer revenues and net income by $575,000. Driving B & C pricing to 4 points above A customer would drive $1.2 million in net income.
  • B & C customer orders drive $390 & $115 in Variable Margin per line respectively. This does not cover labor, overhead, order management, pick & pack and handling costs.
  • About 75% of our line activity drives less than 10% of our variable margin.
    • We need to adapt our processes to manage each segment of our business

The best sales people for this client drove superior pricing at their “A” customers. The more desperate sales people were allowed to decide on pricing at “B” and “C” customers, and it showed. This showed that the company did not have good pricing controls in place. Addressing this drove an increase in EBITDA that was the equivalent of adding over $8 million in new sales.

In addition, 10% of the sales of this company drove 75% of their gross margin. Yet, the treated all SKU’s and customers the same. Seeing this in black and white enabled the management team to develop new channels, adopt some pricing policies on freight and lead times and update their production scheduling approach to protect “A” customers.

In this case, the 9-Box helped the management team see the impact of running the business like a life-style family business. The changes needed to drive the additional EBITDA also increased the service levels to “A” customers and reduced day to day stress throughout the company.

See the link below to download this case study.

Conclusion

While the 9-Box was designed to address inventory strategy, it also brings black and white visibility into actual pricing strategies in practice. It gives the management team, and their owners, a stark and sober look into opportunities to make all of your business segments profitable.

If you would like a copy of the 9-Box Case Study referenced above, click here.

About Bob Sherlock – Marketwerks, Inc.

Bob Sherlock works with executives of manufacturing and B2B services companies whose sales teams lack a compelling answer to “Why should I buy your solution from you—especially when you’re more expensive?” or “Lower your price.”

He helps his clients get paid what their solutions are really worth—and attract customers willing to pay more when they see value.

Bob is president of Marketwerks, a consulting firm focused on those objectives, and the author of Daring Caution: The Executive’s Guide to Pricing Improvement. Earlier, he was a ProAction Group principal, and founder of a venture-funded logistics service provider. Bob previously served as VP—Marketing for Wickes Lumber, and held increasingly responsible marketing and sales management positions in four GE operating businesses and on GE’s corporate marketing staff. He has an MBA from Dartmouth’s Tuck School of Business.