A Product Innovation that Reduced Overall Product Sales

Innovation generally increases sales of a given product category. The product improvement creates more customer satisfaction- and drives more sales. Mobile devices are a great example. Innovation allows manufacturers to add more features to mobile devices all the time. The user can take better pictures, access websites faster, play music with more clarity. As a result, the product is used more- and customers are willing to upgrade. If there is more demand, the manufacturer can increase the price- all good stuff!

A recent article explained a product innovation that has reduced overall product sales- detergent sales (“Is Innovation Killing Soap Sales?”, Wall Street Journal, 4/4/13).

Proctor and Gamble’s innovation was to create premeasured pods for laundry detergent. No need for the customer to measure the powder or liquid in a measuring cup. The shift to pods (which is increasing) has reduced overall sales of detergent. Why? Customers pour too much liquid or powder into every load. Consider these issues:

• ·            Customers who buy liquid detergent the large sizes didn’t “feel guilty” about overusing the product because they paid a quantity discount.
• ·            Companies now market more highly concentrated liquids and powders. The more concentrated the product, the more careful the customer must be to avoid waste. In other words, the buyer must be more careful about measuring the concentrated product.

 The pod innovation has reduced product waste- and customers are buying less product.

There is another trend working against powder and liquid detergents. More customers are using high-efficiency washing machines  “which clean with relatively little detergent”.

One last trend: the profit margin on the pod detergent is currently lower than on liquid or powder. That’s because the wholesale price for the pod detergent is high. The retailer doesn’t want to add a large markup, because they risk losing pod sales to low priced competitors. So, the product that people are moving toward- pod sales- is less profitable!

So, how can a seller maintain a reasonable profit level? Well, raising prices doesn’t seem to be an option- for the reasons mentioned above. If you want to “widen” the difference between costs and your sale price, if can’t change the sale price part of the equation.

The solution must be on the cost side. As times goes on, maybe the manufacturer can reduce the production costs for the pods. That might mean that material costs decrease, as the producer buys larger quantities. Or, maybe the manufacturer finds ways to reduce machine and labor costs- they learn how to produce the product faster, more efficiently.

This is a great cautionary tale: innovation is great for consumers- but how will it impact your firm’s profitability?

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Audit Reports: What, Exactly, Are You Reporting?

I find that the auditing section of the CPA exam is a difficult area for many exam candidates. Auditing, more than any other topic on the CPA exam, is best explained with “real life” examples. I describe the audit section as more of a business law exam. That’s because audit reports and related disclosures read like legal documents. Real life examples can help the student break through this legal language and understand the topic.

What an audit report says:

If you were on an elevator and someone asked you what an audit report says, how would you respond? Keep in mind that you only have a minute or two.

Here’s my response: An audit report documents the auditor’s opinion that the financial statements are materially correct. By materially correct, the auditor is saying that they didn’t find any errors large enough that would change the financial statement reader’s opinion of the financial statements.

Let’s assume your considering buying a restaurant. As part of your due diligence, you read the audited financial statements. If the financial statements contained an immaterial error, that error would not change your view about the financial health of the restaurant.

What an audit report does not say:

·            An audit report does not say that the financial statements are free of all errors. You just learned that the report might contain immaterial error.

·            Fraud: Fraud is defined as “willful intent to deceive”. Fraud normally involves collusion. If two or more employees work together to commit fraud, they are colluding. An audit is not designed to detect fraud. If employees are attempting to defraud a company, typical audit procedures will not detect fraud.

A good example of fraud is creating a fictitious payee (which I have bogged about- search my blog for that particular posting). Say an employee creates a fictitious company and has the employer write checks to that firm to pay bogus invoices.

Typical audit procedures may not catch this fraud. That’s because an auditor assumes that the company’s internal controls over financial matters are used by employees. If workers are colluding to commit fraud, they certainly are not following the company’s internal controls!

What’s an audit- and what’s not an audit:

An audit is an opinion- in fact, the letter is called an “audit opinion”. Usually, the last paragraph of a standard audit report starts with: “In our opinion”…. You may hear the term that an auditor is “opining”…not sure if that’s a real word, but there you go.

Other work performed by CPAs are not audits. Reviews and compilations are not audits. In general terms, the CPA is verifying the “the numbers are in the right boxes”. By that I mean that the financial information is in the right format. For example, assets and liabilities are grouped into short term and long term categories. Important: an auditor is not giving an opinion in a review and compilation. Since there is no opinion provided, the auditor will likely do less work than they would in an audit.

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Rice, Corn and Soybeans: Making Decisions About Sales Mix

Sales mix is defined as the proportion of your total sales that one type of product represents. If your clothing shop sells $1,000 of red shirts and $2,000 blue shirts, red shirts represent 1/3^rd ($1,000 / $3,000) of your total sales. The sale mix is 33% red shirts and about 67% blue shirts.

Sales mix is an issue, because nearly all businesses sell more than one product. Different products may have different levels of profit. Specifically, think about profit margin, or (profit in dollars)/ (sales in dollars).

Consider the shirt example. Say you earn a 20% profit on the red shirts, and a 10% profit on the blue shirts. Your goal is to maximize total profit. If you shift your sales to the product with the higher profit margin (red shirts), you’ll earn more total profit.

Farming is a great business to illustrate sales mix. A farmer has a big decision to make: how much of my available land do I use for each available crop? A farm can produce different products with the same land. Which products will generate the highest total profit for the farm?

An April 2013 Wall Street Journal article, “Farmers Lose Their Taste For Rice”, explains why some farmers are shifting away from rice production.

The farmers are in Louisiana, Arkansas and Mississippi. They can produce corn, soybeans or rice. Here are the factors that move them away from rice production:

·            Comparatively low prices for rice: Corn and soybean prices have spiked, due to less crop produced during recent droughts. Rice prices have not increased at the same rate. According to the article, corn prices have increased 50% due 2008 (about 5 years), while rice prices are flat during that same period.

·            Higher labor and equipment costs: “Rice is more labor-intensive and requires more farm equipment per acre than corn and soybeans.” That’s because rice must be submerged in 4 to 6 inches of water for most of it’s growing season. So, a farmer must build levies around each section of the field. The fields must be irrigated to maintain the correct water level.

Consider the work involved to switch production to corn or soybeans. You’d have to remove all the levies and level the fields. The change in production from one product to another is a setup cost. Whether you’re building levies and planning irrigation (or removing levies), you’re incurring labor cost and using machines- and incurring more cost.

·            Risk of poor product quality: The article explained a low quality rice harvest is harder to sell than a poor quality corn of soybean crop. So, if a drought or infestation affects your crop’s quality, you rather have corn or soybeans than a rice crop.

Given the additional costs and risks of growing rice, I’d have to have a higher profit margin than corn or soybeans- maybe a lot higher. If my corn and soybean profit margin was 10%, I might not plant rice unless the margin was 20%. If the rice production didn’t go as planned (higher labor or machinery cost, quality problems), I’d probably have a lower profit margin. If the profit level on rice declined to 12%, I’d still make more than the other two crops.

The article concludes that low prices, higher costs and the risk of poor quality are forcing farmers to stop rice production- and possibly never go back to that product. Using my example, these famers are willing to accept a 10% profit margin on corn and soybeans- and avoid the uncertainties of rice production.

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Ken Boyd

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