Improving profits for ChocCo

ChocCo is a small boutique WA confectionery manufacturer that started about five years ago. Sales have risen steadily in those five years, yet in the last 2 years profitability has fallen. ChocCo’s management team has asked you to find ways for it to improve the situation.

What precisely does ChocCo sell?

ChocCo produces and sells one chocolate product, the ChocCo generic bar.

You mentioned that sales have been rising throughout the chocolate bar’s life. Does this include the last 2 years?

Yes.

As a generic product in a fairly commoditised market, I would assume the price of the product has grown in line with industry prices. Given I know that chocolate bars have not decreased in price, I suspect the declining profitability is caused by costs growing. Is that correct?

Yes that is correct. Product price growth has been in line with the market which typically mirrors inflation.

Ok. In that case, my approach is to analyse how fixed and variable costs have tracked over the past 5 years to identify which costs have driven the overall cost increases. Next, I will analyse the cost buckets in detail to determine the reasons for those cost increases. Finally, I will explore potential ideas to reduce the costs.

That's a good process. Let’s proceed.

Do you have any data on how fixed and variable costs have tracked over the past 5 years?

Here is some data. How would you interpret it?

Fixed costs have been fairly constant and given that production has increased, I expect that fixed costs per unit have actually declined. Variable costs on the other hand have increased. Variable costs should increase with production but they should not increase on a per unit basis, otherwise we may have exceeded our optimal level of production.

Do you have any data to breakdown variable costs into its components as well as annual production?

What cost items do you think comprise variable costs?

I’d expect that raw materials purchasing, packaging and employee wages are likely the biggest variable costs.

Good. Here is some data. How do you interpret it?

Production has increased from 1.5M to 2.5M in 5 years, which is a 67% increase. We should expect that variable costs would increase by no more than 67% in line with production and that some items should actually decrease as the company becomes more cost effective at producing.

It seems that employee-related costs (salaries, safety and training, and insurance) have grown by more than 200% since 2005 and are the root cause of the cost increase.

The cost of Ingredients have increased nominally by 67%, but per unit produced there was no rise, while Packaging actually decreased by 10% per unit produced. These costs, and the cost of Utilities (which is small and unchanged) would not be the cost I first address. But due to the size of Ingredients and Packaging as a proportion of variable costs, even small reductions in their size would provide ChocCo with a cost benefit. As an early idea, we could consider renegotiating the purchase prices or preferred supplier for both Ingredients and Packaging.

Not to be forgotten is the other production cost, which per unit has increased 40%.

What do you think could cause this increase?

An increase in Employee-related costs can be caused by increasing the number of employees  at a rate faster than production growth, or by increasing costs per employee or both. Here it is both:

• Number of employees has increased from 10 in 2005 to 20 in 2010. Given production has increased by only 66%, the number of employees should have increased by no more than 7; what we are witnessing is that employee productivity has declined.
• These employee related costs on a per person basis have also increased significantly:
  • Salaries have increased from $30K per employee to $45K
  • Safety and training programs have increased from $10K to $20K per employee
  • Employee insurance has increased from $2K to $3K per employee

Good. So what do you think ChocCo should do?

Firstly, unless ChocCo believes that the market is big enough to warrant 20 employees, ChocCo should look to reduce the number of employees. Secondly, ChocCo should look for ways to reduce per employee costs. This could be achieved by better linking salaries to sales, and looking for cheaper providers of safety and insurance. Thirdly, to reduce Other Production Cost, ChocCo should reconsider the cost effectiveness of its strategies regarding marketing, distribution, sales, etc.

Is there anything else?

Employee turnover has also increased disproportionately in the past few years. ChocCo should  determine what the reasons are for this and remedy the situation.

Thank you.