Increase Profits Without Adding Resources Part 3

In this segment we’re going to explore two more profit drains – quality and payment terms.  Sound a little mundane?  You’ll be surprised at the savings you can generate.

Quality

I’m sure that most of you are expecting me to talk about lack of quality.  After all, it’s poor quality that costs you money in rework, callbacks or fixes.  All of these terms describe the effort associated with redoing the original work so that it satisfies the customer.  There’s no question that this is a profit drain, but it’s not our focus today.  We’re going to explore the cost of providing quality.

I know that it seems strange to think of quality as a potential profit drain, but here’s an insight I got from a printer.  He asked “Dale, when a customer walks through my door which do you think he’s more likely to buy, a good print job or a great print job?”  “A great print job!” I replied.  He smiled one of those Gotcha! smiles and said “Most people can’t tell the difference between a good print job and great print job, yet the cost is dramatically higher for a great print job.”

His message was clear; he didn’t sell many great print jobs because his customers couldn’t see the difference between good and great.  How often do we increase the quality of our offerings without checking to see whether the customer values the additional quality?  How often do we look at quality as a way to differentiate ourselves from our competitors, all the while assuming that the customers will pay more for the additional quality?  As our printer so astutely noted, customers aren’t always willing to pay for higher quality.  The solution seems simple, don’t add quality unless the customer is willing to pay for it, but what happens when your employees provide quality greater than the contract requires?

A concrete contractor client experienced that problem.  One of his finishers was a perfectionist.  He did beautiful work, but he wanted to apply the same level of quality to a cul de sac street that he would to a patio, sidewalk or driveway in a custom home.  Custom homeowners are willing to pay for higher quality (aesthetic appeal), land developers aren’t.  My client experienced lower profit margins on street paving jobs involving this finisher.  How do you deal with this problem?

The first thought that comes to mind is simply to let the guy go.  Certainly that’s an option and it may be the best option if all of your work is street work.  He simply isn’t suited to the type of work you do.

If you do both street work and custom work as my client does, a better alternative is to limit his involvement to those jobs requiring the level of quality he likes to provide.  In other words, use him only on custom work jobs where the customer is willing to pay for higher quality.  If you can’t keep him busy full time, direct some of your marketing efforts to acquiring more custom business.  The profit margins are typically very good on custom work.  Match your employee’s penchant for quality with the customer’s desire for quality and you’ll profit handsomely.

If you want to avoid having quality become a profit drain, use this two-prong approach:

• Make sure your customer is willing to pay for more quality before you begin a quality improvement initiative.
• Monitor your employees performance to assure they aren’t providing more quality than the contract requires.

Now, let’s turn our attention to payment terms – not yours, your vendors.

Payment Terms

What’s your attitude toward your vendors’/subcontractors’ payment terms?  Do you abide by them religiously?  Do you allow yourself a little extra time, possibly a week or two?  Or do you take as much time as you like?  The choice you make can have a dramatic impact on your bottom line.  How much?  To answer that question I’m going to ask you to switch roles and become the vendor/subcontractor so that you can use your cost structure to quantify these costs for your firm.

Let’s assume that you have three customers.  They’re all paying the same price and they all have agreed to the same 30-day payment terms.  One pays on time, the second pays about two weeks late, the third pays at about 75 days.  Obviously, the one that pays on time is your most profitable customer.  The other two are successively less profitable.

Let’s further assume that all three call with an urgent request, but you can only accommodate one of them.  Who’s going to get their request granted?  The one that pays on time, right?  The others will either wait for your availability or devote time and energy to trying to find another source to satisfy their needs.  What are these options going to cost them?  If they decide to wait for you here are some of the costs might they incur:

• Down time
• Productivity losses associated with shifting personnel from one job to another (and back again when you become available)
• Penalties for late delivery

This brief list will help you quantify some of the costs you incur when you have to wait on your vendor/subcontractor.  Costs that you are more likely to incur if you consistently ignore their payment terms.

If your vendors/subcontractors choose to find another source rather than waiting for you, the costs they’ll incur include:

• Purchasing’s time spent trying to find another source that’s available
• Risk of callbacks (rework) caused by inexperience with your production standards/processes
• Higher prices (you’ll charge extra to accommodate the quick turnaround they request)

Again, these are the same costs you’d incur if your vendor/subcontractor put your request off because you’re not paying on time.

There is one more cost you are likely to face as a result of your penchant for paying late – higher prices.  If you have a customer who typically pays around 75 days when your terms are 30 days, aren’t you going to build an interest factor into your future pricing?  You bet you will.  How expensive can that be?  Here’s an example that will help answer this question.

Again, I’m going to ask you to change roles and become the vendor/subcontractor.  A customer who does $300,000 worth of business with you each year typically pays you at 75 days rather than the 30 days you require.  The current interest rate is 9% on a line of credit loan (I know that rates are much lower now, abnormally so, that’s why I’ve chosen a more traditional rate).  How are you going to adjust your pricing to this customer to compensate you for his late payments?  Here’s the method I’ve seen used most often in my 13 years of consulting work.

Take the 9% interest rate and divide by 12 months to arrive at a monthly interest rate of .75%.  Next you multiply that rate times the number of months he’s late.  In this case the customer is 45 days, a month and a half, late.  At this point many people round up to two months.  Why?  The math is easier and you cushion yourself against even slower payments in the future.

Continuing with the math, you’re going to raise his prices 1.5%, .75% times two months, right?  Not likely!  There’s something about quoting price increases with fractions in them that sounds a little weak.  Do you really believe you’re only worth 1.5% more?  Why not 2% more?  Of course you’re worth 2%.  2% it is!  You can see how this whole methodology lends itself to rounding up.  You rounded from 45 days to 2 months.  Now, you’ve rounded the price from 1.5% to 2%.

Most customers won’t change vendors/subcontractors for a 2% increase.  Why?  They’re afraid of the learning curve and its attendant mistakes as well as the uncertainty regarding the new vendor’s/subcontractor’s dependability.  Voila!  You have your price increase. Now, let’s compare the cost to your customer of borrowing the money to pay you on time vs. the 2% price increase he’s accepted.

Borrowing vs. Price increase

Original sales volume - $300,000

9% interest for 45 days (75 –30) -  $3,329

2% price increase - $6,000

The price increase costs 80% more than the interest.  That’s without considering the waiting costs mentioned above (down time, productivity losses, penalties) or the costs of acquiring a new vendor/subcontractor (purchasing’s time, more callbacks/rework, higher pricing for a quick turnaround time.  As you can see, ignoring your vendors’/subcontractors’ payments terms can be a serious drain on your profits.

Now, I’m not saying that your payment must be there on the exact day it’s due to avoid these costs.  Most vendors/subcontractors consider a payment within 5 days of their terms (35 days on a 30-day term) to be timely.  If you consistently pay within 5 days of the terms, you’ll be a valued customer.  One whose requests are given high priority and whose price increases do not include interest factors.

If you want to increase profits without adding resources – make sure you get paid for the quality you provide and pay your vendors/subcontractors within 5 days of their terms.

Copyright © 2002, Dale Furtwengler, all rights reserved