Case Scenario:
A few years ago we looked at a small business that made a Play Dough-like product called "Dazzle Magic." This product was differentiated from the standard (Play Dough) product in the early childhood industry (preschool, grade school, home) by color and scent. Grape, orange, cherry, banana scents etc., with the usual associated colors were the distinguishing features. It also clamed to stay workable longer - a plus when dealing with small children. A wife and her husband owned it. Both had quit former professional jobs to do this full time. They were shipping about 20,000 pounds per month from rented space that also served as the production and administrative facility. Only one problem, a shortfall of about 5,000 pounds per month from reaching cash break even. Running out of cash resources they had begun the search for investment capital. Later on in the week they were going to talk to the bank about a loan.
At this time the company had no real lasting competitive advantage. The product had gained an initial toe-hold through differentiation selling mostly through catalogue and retail outlets such as Lakeshore. They were underselling the competitive product but without a cost advantage. Could this strategy hold out until volume increased to break even? Could the company survive the undetermined period of negative cash flow? As you might expect, the answers were an optimistic "yes" (from the owners) because the break-even volume was just around the corner.
The problem with this strategy is you must have the financial resources. It is not a good strategy for a small company. I suggested three changes in our meeting all of which were answered by "we can't do that."
1. Cut overhead by contracting out the manufacturing
2. Establish direct customers
3. Raise price
The overhead cut was rejected because the owner's son ran production with some friends. What would he do if the company did not do its own production? "And no one else can make the product like we can, we really care for the product", they both chipped in. I suggested several companies who could do the work, even ship the product, and allow the company to exchange a fixed cost for a variable cost. You know by now this will dramatically reduce your break-even point. But again the "we can't do that" excuse prevailed.
The establishment of direct customers raised considerable debate. My reasoning was these customers would appreciate the product differentiation and pay at least enough to create positive cash flow even on the present volume. I was told, "our distributors would black ball us". I offered several ideas to get around this potential conflict that would be good for both company and the distributors. I further explained that low cost and differentiation strategies will kill a small company. This is why I always advise early stage companies to go direct rather than through distribution at the start. Establish your own direct customers first who appreciate your differentiation and will pay for it. Again the answer was "we can't do that."
One of my must successful ventures involves a product sold to the professional eye care industry. This is exactly what we did. Tempted to go first to distribution for volume (even if they would listen or care), we went direct first. At the same time we cut overhead to the bone and kept most of the costs variable by finding people to do the work for us. Even answering the phone and taking orders was outsourced on a per order basis and the same with production. Yes it was slow. We first sampled all the professional eye care providers in Colorado and California. About 5,500 names total. As this volume grew we expanded to other states. It took about 3 years to say we were serving all the states, which total about 37,000 prospects. After the first several months we were cash flow positive and have been ever since. By the way - when we finally did take on distributors it was on our terms because their customers were demanding our product.
And finally the raise price issue appeared to be the most appetizing but then excuses started to surface. I showed them that even a 5% increase would turn the cash flow positive. And 5% would be hardly noticed even by their distributors. After all they were 50% below the Play Dough price so, 45% below would still give the distributor's customers a significant price option. Finally, I explained, to get the same effect on cash flow you would have to reduce fixed costs by 23%. Where would these cuts come from? I was sure I had a convincing argument now. Well I was wrong again - "we can't do that."
PS: On the second meeting we parted company with "Dazzle Magic." And, so did the bank.
1. In the "Dazzle Magic" situation discuss the implications of one important financial management issue.
2. What is the most important financial management issue facing companies in the next 5 years?
3. Select the most significant area in the finance course, one for you personally, and explain how your understanding of business finance has changed.