Chapter 8: Consultative Proposing Strategies—How to Quantify PIP Solutions
Customer profit improvement begins with knowledge of how customers make the profits that you are going to improve: how they make their money right now. This is the starting point for Consultative Selling. Unless Consultative Selling strategies can improve the profits a customer can make, the customer will not be a prospect for high-margin sales.
A customer makes money based on five principles:
Return on investment (ROI)
Applying the Circulating Capital Principle
Profit is made by the circulation of business capital. Every business is founded on capital or funds that start in the form of cash. The objective of business is to make the initial cash grow into more cash. This is accomplished by circulating the capital, the initial cash, through three transfer points. Each transfer adds value:
The initial cash circulates first into inventories.
Then the inventories circulate into receivables.
The receivables finally circulate back into cash, completing one cycle.
This three-step process demonstrates the principle of circulating capital. Every business depends on it for its income.
Circulating capital is the current assets of a business. They go to work in profitmaking as soon as cash is invested in accumulating inventories. Every time raw materials are purchased or processed, inventories come into existence. Another name for production scheduling could really be inventory conversion. Manufacturing adds further to the value of inventories, and so do all the other processing functions of a business that transfer value from cash to product costs on a dollar-for-dollar basis.
Figure 8-1 shows the profitmaking process that occurs as capital funds circulate through a customer's business. At A the funds are in the form of cash. As the business operates, the funds change form. The initial cash is transferred into inventories as raw materials are purchased, labor is paid, and finished goods are manufactured and transported from plant to warehouse.
Figure 8-1: Profitmaking capital circulation.
When sales occur at B, funds flow from inventories—the manufactured goods—into receivables. As they flow, the magnitude of the funds increases because inventories are valued at cost and receivables are valued at selling price. This increase represents the gross profit on sales. The greater the gross profit rate, the greater the increase in funds during each rotation of the capital circulation cycle.
At C, the funds earned by the collection of receivables flow back once again into cash. Before they do, they are reduced by the sales and administrative expenses that have been disbursed throughout the operating cycle.
At this point, one full cycle of capital circulation has been completed. It has resulted in an increase in the number of dollars in the circulating capital fund. This increase is the difference between gross profits and selling/administrative expenses. In other words, a profit is made when the circulating capital of the business turns over one cycle. The more cycles through which you can help turn your customer's circulating capital during an operating year, the greater the profit the customer can earn. This is the principle of turnover.
Applying the Turnover Principle
The circulation of capital funds in a customer's business takes on meaning only when it relates to time. Since capital funds turn over in a complete cycle from cash to inventories, then to receivables, and finally back into cash again, their rate of flow can be measured as the rate of turnover. The faster the turnover, the greater the profit.
Stepping up a customer's turnover rate through profit improvement is the consultative sales representative's most important function. Unless your profit projects are by and large directed to improving the turnover of the capital employed in your customer's business—especially the capital that is in the form of inventories—you cannot accomplish your mission.
As with all products, the principle of turnover is crucial to maximize the value of the PIP process. PIPs are capital. It must be turned as fast as possible in order to maximize profit growth. As inventory, PIPs represent a cost. Only by being closed can their cost be reclaimed and their value begin to be realized.
PIPs in inventory account for two kinds of cost. One is the sunk cost of their manufacture. The other is the opportunity cost of remaining unsold. But PIPs do not just sit in inventory. They are perishable, losing their net present value to obsolescence or competitive replication. Their half-life grows shorter daily.
Turnover generally offers more opportunities than any other strategy for profit improvement. The most common way to improve turnover rate is through increased sales volume and lowered operating fund requirements. In some situations, turnover may be improved by decreasing sales or even increasing the investment in operating assets.
You are in excellent position to help improve a customer's turn of circulating capital since, as Figure 8-2 shows, the drive wheel that rotates capital is sales. You must continually search for the optimal relationship between your customer's sales volume and the investment in operating funds required to achieve it. At the point where the optimal relationship exists, the turnover rate yields the best profit.
Figure 8-2: Profitmaking turnover.
In Figure 8-2, the circumference of the sales wheel represents $200,000 worth of sales during a twelve-month operating period. The sales wheel drives a smaller wheel representing circulating capital. The circumference of the circulating wheel equals the amount of dollars invested in working funds, in this case $100,000. Enclosing the circulating capital wheel is a larger wheel, also driven by sales, that represents the total capital employed. It includes the circulating capital of $100,000 plus another $100,000 invested in plant and facilities. Thus the circumference of the wheel representing total capital employed is $200,000, equal to the sales drive wheel.
When annual sales are $200,000 and total capital employed in the operation is $200,000, the annual turnover rate of total funds invested is 100 percent, or one turn per year. The portion of the total that is circulating capital, amounting to $100,000, turns over at the rate of 200 percent, or twice a year.
Each of the three elements of circulating capital—cash, receivables, and inventories—has its own individual turnover rate. Inventory turnover is calculated according to the number of months' supply on hand. A six months' supply represents two turns per year, or a 200 percent annual turnover rate. Turnover of receivables is expressed as the number of days' business outstanding. If ninety days of business are outstanding, the receivables turnover is four turns per year, or 400 percent.
Since circulating capital increases every time it completes one turn, your job is to find ways to increase customer turnover through the use of your product and service systems. You can exercise two options for improving turnover. One way, option A, is by increasing sales. The other way is by decreasing the amount of money invested in circulating capital, option B. Figure 8-2 shows an opportunity to double customer sales to $400,000 per year without increasing the $200,000 of total funds employed in the business. This is option A. The turnover rate is increased from 100 to 200 percent. At the same time, the turnover rate of circulating capital increases from 200 to 400 percent.
If the consultant cannot increase the customer's sales, option B offers an alternative opportunity to improve turnover. Even though sales remain at the same annual rate of $200,000, turnover can be increased if total capital employed is reduced from $200,000 to $100,000. This includes a parallel reduction in circulating capital from $100,000 to $40,000. These reductions help the consultant improve the turnover rate of total capital employed from 100 to 200 percent and that of circulating capital from 200 to 500 percent. This strategy for improving turnover means that the operating funds of the customer's business are being worked harder.
The profit improvement created by options A and B can be readily appreciated by multiplying the increase in funds generated at each turn of the operating cycle by an increasing number of turns. If the operating profit from one turn in the basic relationship shown in Figure 8-2 is $50,000, the profit realized by option A is doubled to $100,000. In option B, profit remains at $50,000, but $100,000 of funds are released from operations that could be used to generate additional business or reduce indebtedness.
Opportunities abound for improving a customer's turnover. The reason is simple. The sum total of funds employed in a customer's business represents the many individual funds that make up circulating and fixed capital. An improvement in the turnover of any one of these funds correspondingly improves the turnover of the total funds employed. Therefore, you can zero in on any component of a customer's "turnover mix" without having to consider any of the others or their sum total. For example, improvement in the turnover of any single item in a customer's inventory—including your own product—improves total turnover and consequently contributes to profit improvement.