The CFO'S Perspective

This article is specifically focused on the issues and problems that a significant sales increase (30% plus increase due to activities such as a new product line, a new distribution channel, or a major new customer) can have on the existing organization that could potentially offset the gains from the increased sales if not properly addressed or anticipated.

When there is such a profound change in an organization due to significant growth, there are many ways this anticipated windfall can turn into an albatross and bring a company to its knees or reduce the anticipated benefit of profit.

I am taking an accountant’s approach to understand the impact of a significant increase in sales can have on an organization. I will take you through the components of an income statement and balance sheet to discuss how each line item can be adversely impacted by a seemingly windfall in sales and profits.

Sales/Customers

When there is a significant change in product line or distribution, it can cause confusion with your current customer base, such as:

1. Quality differences that are inconsistent with the current brand image (quality vs low cost).
2. Will a new brand need to be established?
   • If so, what is the cost?
3. Different pricing that confuses current customers with similar products (or perceived as similar).
   • Will current pricing need to be reviewed or modified?
4. Different terms or discounting that may or may not pertain to current customer base.
   • Will they require comparability?
5. Will existing distribution channels be used (for efficiency) or will new/additional channels be established (less efficient)?
6. Will there be a change in promotional spending?
   • If so, will it confuse your current customer base? Will they require the same?
7. Will there be inconsistent freight policies adding to billing/system complexity?
8. Will the new sales be incremental, or will there be cannibalization?
   • Depending on profit margins do you want cannibalization?
   • Will your anticipated incremental sales be reduced but at potentially increased profitability?

Cost of Goods Sold/Vendors

With a new product line or major new customer there may be changes to your production process which can add to the complexity and inefficiency and also adversely impact overall cost of goods sold on your existing business. For instance:

1. Will materials be handled differently with the new product line such as lot traceability?
   • Will this change cause inefficiencies in material usage or the cost of handling?
2. What will the impact be on inventory levels and vendor discounting?
   • Will there be common parts leading to volume discounting with current vendors, or unique parts which may require new vendors with reduced terms/discounting?
3. Will QC/QA requirements be the same for the new product line?
   • If not, there may be additional costs, added complexity, confusion and inefficiencies of multiple QC programs.
   • This could lead to having a QC standard set to the most stringent requirements (inspections, registrations, sampling, traceability etc.) which could add significant costs.
4. Will the new product line create a need for changes to processes that could adversely impact current labor efficiencies?
5. How does the new sales volume impact labor capacity?
   • Additional production shifts?
   • Additional production supervision?
6. When expanding capacity, is there a need for more machinery, production or warehouse space (adding to overhead costs) or will current resources be more efficiently utilized?
7. Will the added sales and production volume improve the absorption of overhead costs or will the capacity additions and labor inefficiencies increase your overhead rate?
8. Other manufacturing expenses that may be impacted are:
   • Manufacturing management and their capacity to handle increased volume and complexity and the additional repairs and ?
   • Maintenance on existing machinery and facilities that increased volumes would impact.

Sales and Marketing Expenses

With a new product line or a major new customer, the existing sales and marketing structure may be adversely impacted. Examples include:

1. Will the existing sales and distribution channels be used which would improve efficiency?
   • Or are new channels needed which can cause complexity and potential confusion with existing channels resulting in inefficiencies?
2. Will there be different sales compensation plans needed which can cause confusion and/or complexity?
3. Will the sales organization need to be modified?
4. Could there be a cultural impact on the existing sales force?
5. Will there be a change in promotional spending which may cause confusion with your current customers and add complexity to transaction processing?
6. What training needs are required for sales staff for the new product line or major customer?
   • If training is needed, what is the cost and timing?
7. What incremental marketing costs are needed for the launch of a new product line or customer and how does that fit with the current marketing programs? Examples:
   • Trade shows
   • Road Shows
   • Samples
   • New Distribution channel subsidies

Administrative Expenses

Many times, the impact on administrative expenses is overlooked due to the perception that Admin Expenses are fixed. Some potential impacts are:

1. Increased volume and potential complexities mentioned above may impact transaction volume and complexity.
   • Does this impact current headcount or admin organization?
2. Increased complexity may stress current computer and ERP systems.
3. Increased need for cash relating to inventory build, marketing costs, and accounts receivable may stress current financing and cause the need incremental lending. (See Balance Sheet comments below.)
4. Will the current executive level staff have the skills and ability to handle the increased complexity?

Balance Sheet/Cash Flow

As already mentioned, any increase in sales and especially when there is a significant increase due to a new product line or major new customer, may have a significant impact on cash flow due to such things as:

1. Increased inventory which is impacted based on whether there are common materials or unique materials, and whether new vendors with restrictive terms are used.
2. Increased accounts receivable due to sales volume increase and any changes to payment terms.
3. Increased investment in machinery or facilities.
4. Increased product launch expenses.
5. How will this increased funding requirement be fulfilled?
   1. Increased Bank Debt
   2. Increased Equity contributions
   3. New Equity partner
   4. Other partnerships
   5. Merger

In Summary

The lure of a significant increase in sales can sometimes overshadow the analysis of what it will do to the current organization and production processes. The potential negative impact on the existing organization can many times reduce, or potentially eliminate the potential profit increase expected.

The objective of growth in any business should be to ensure the increase in sales volume results in the desirable increase in profit. A term used when this is not accomplished is “Empty Volume”, when increased sales does not result in increased profit (Empty).

The warning here is to thoroughly look at not only the new business but to do a thorough analysis of the impact on the current business before going down this road to avoid Empty Volume and the unintended impacts it can have on your business.

About the Author

Roger Johnson has more than 30 years of private and public company experience as CFO, VP of Finance, Controller, and Director of Finance and Administration. His industry background spans manufacturing, distribution, supply chain, and financial services industries. Roger has over 20 years of extensive international experience in Asia and Pacific Rim countries and was an expert Foreign Lecturer in the People's Republic of China for the Central Institute on Finance. Roger received his accounting degree from the University of Illinois and an MBA from Pepperdine University.