In my last blog on this subject (The Magic of SBU Analysis ), I described how the typical income statement masks the real causes of performance (both good and bad) for all but the simplest of companies. I suggest you read that article before reading this blog.
So, let's take a look at another company which has more than one group of customers and products/services. The example here is for a hypothetical swimming pool/spa firm (disclosure: I served on the board of such a company for several years, but the example does not portray the performance of that firm).
The traditional income statement for this firm looks like this:
As portrayed in the first blog, the cost of sales includes direct labor, materials and managerial expenses. The first takeaway is that this firm, in the year shown, has $600,000 to cover all other expenses (i.e., rent, insurance, utilities, etc.) and pre-tax profit.
Unfortunately, this traditional income statement does not give a true picture of where the company is making money—or losing it—because it lacks the detailed examination of the profitability of customer groups and product/service groups.
This firm has three Strategic Business Units (SBU): Pool Design, Chemicals, and Repairs/Maintenance. The analysis of those three SBUs shows the following:
Obviously, these three SBUs are not equal in size or performance. And that is typical when you employ an SBU analysis of performance. Without knowing anything about any given company's SBUs, I already know two things:
Not all SBUs are created equal in size and/or performance.
Not all SBUs have the same potential for growth and profitability.
So let's dig down some more. Each of these SBUs have distinct customer groups into which the firm sells. Let's take them one at a time.
Pool Design
Pool Design is a relatively specialized service few pool service companies offer, and this SBU represents a distinctive competence of this firm. From a cost standpoint, most expenses are for highly skilled engineering talent and CAD hardware and software. This portion of the business is highly cyclical—in a slow year, the full talents of an engineering staff are underutilized; in growth years, the full time engineering staff is hard pressed to handle the volume. Contract labor is adjusted up or down to keep the SBU in balance. Design frequently presents add-on opportunities to capture new Chemical and Repair/Maintenance customers. This SBU has two separate sets of customers: Municipal/Institutional customers and Hotel/Fitness Center customers.
Let's see what this SBU looks like when breaking it into two SBUs:
This is one of those rare times where both SBUs have the same Gross Margin percentage. If viewed from a new customer acquisition process, these two SBUs are "keepers" as long as labor costs are kept under control.
Chemicals
Pools and spas require regular testing and chemical products to maintain water quality. Chemicals are delivered via tank trucks (larger quantities) and in smaller containers that might be delivered with small vans or pickup trucks. In either case, but especially in the case of the tank trucks, drivers must have commercial licenses and all personnel need to have HAZMAT certification. This area of business serves three separate customer groups: Home, Municipal/Institutional, and Hotel/Fitness Centers.
Let's see what these SBUs look like:
The Home customer SBU carries the highest margin as well as the highest sales. Deliveries can usually be made one or two times per month in season and often with less expensive driver labor. Municipalities and Institutions tend to be larger volume accounts that are serviced more often than the Home customers and usually by the higher cost tank trucks. Because of the gallonage requirements of these customers, other pool supply firms often bid at low margins to capture the volume business. It should be noted also that municipalities and sometimes institutions tend to pay slowly. The Hotel/Fitness segment presents many of the constraints in pricing and delivery found in the Municipal/Institutional market, but the margins could be higher because of other relationships (i.e., the firm's Design SBU might give a leg up on the competition).
So, this level of analysis for the Chemical market present very different sales volumes and margins. If the owner has a choice, which of the three SBUs would he want to grow, given the above information? If this level of analysis were not available to him, he would have to make strategic decisions with insufficient information about profitability and volume.
Repair/Maintenance
This segment of the business is a logical extension of services to Chemical customers as well as those who don't buy pool/spa chemicals from this firm. The major requirements in this SBU are for trained and experienced service technicians who have good trouble-shooting and problem-solving skills. Obviously, these technicians require a service vehicle and appropriate tools. They tend to be relatively highly paid, and the firm's ability to control labor costs and hold to established hourly billing rates is essential to success. The Repair/Maintenance segment services the same three customer groups as the Chemical segment.
Let's see what this segment looks like broken into three SBUs:
As with the Chemical segment, the sales volumes and gross margins of these three SBUs are very different from each other. Again, absent this level of analysis, a decision maker would have a hard time determining which SBUs to grow and/or which SBUs to "fix" (such as the Municipal/Institutional SBU, which carries a very low gross margin).
Takeaways
Drilling down inside the business creates a very different picture of a complex (i.e., multi-SBU) enterprise than the traditional income statement provides.
Most businesses that are not organized to capture financial performance information by groupings of customers and products/services need to convert their financial information systems to capture the proper data. In my experience, this could easily be a major goal for the management team for at least two quarters if not more. It requires re-thinking about how the firm does business.
What is shown above could easily be drilled down even further. For example, are there major customers inside a given SBU that are unusually profitable or unusually unprofitable?
Pareto, the Italian economist, came up with Pareto Analysis at least 500 years ago and states that 20% of a typical company's customers make up 80% of the firm's volume. That same 20% may or may not generate 80% of the firm's profitability. Doing a Pareto Analysis SBU-by-SBU frequently provides additional insights and might well be a strategic exercise worth doing.
Jeffrey C. Susbauer, Ph.D. is Associate Professor Emeritus at the Monte Ahuja College of Business, Cleveland State University where he has taught strategic management and entrepreneurship courses since 1970. A long-time consultant to scores of businesses, a member of the boards of advisors to over 60 companies, he co-founded and served as the principal instructor for the COSE Strategic Planning/CEO Development Course for 38 years. This course continues independently today as SPC 3.0. The course is concerned with providing entrepreneurs with education to guide their vision, strategic thinking and execution in their businesses.
Learn more about the SPC 3.0 Strategic Planning/CEO Development Course at SPC30.com