Secure all the rewards of serving a new market demand without tapping your capital budget.
When working with business teams on capacity expansion projects, the expansion is usually needed to serve a perceived market demand. So when framing the question, I ask: “How could we serve this new demand if we had no capital?”
Responses to this question typically come in three waves:
- Suspicion that I have inside information that the company is running out of capital. Next,
- Suspicion that I’m off my rocker… what a stupid question! And finally,
- Serious innovation takes hold once they grasp the intellectual and professional challenge of solving the problem without throwing money at it.
This question usually produces a handful of interesting ideas – sometimes a spectacular idea. But eventually, to signal they are out of ideas, someone blurts out, “We could just say goodbye to some existing customers!” While they thought this was obviously ridiculous, they may have just landed on the best solution.
MIT’s Jonathan Byrnes asserts that forty percent of a typical business’ products and/or customers are unprofitable (see Islands Of Profit In A Sea Of Red Ink).
I can’t vouch for Byrnes’ percentages, but we almost always find a significant portion of current capacity serving unprofitable or at least breakeven business. If that’s the case, then jettisoning that business to create capacity for new profitable business may well be your best solution.
Don’t get misled by cash flow return calculations. If I’m measuring against current operations, the expansion project may well produce a solid return – but it’s an illusion.
Question: If I can serve that new market and reap all its margin benefits without spending a dime of capital (i.e. by displacing breakeven business), what does a capital expansion actually buy me?
Answer: Only the ability to continue serving my breakeven business.
Ouch! From that perspective, expansion generates a negative return on capital.
(Note: This often holds true even for not-for-profit sectors such as heath care or social charities, but their dynamics require a different approach)
Yes, our world is more complicated than cost accounting may reflect. For example, we might truly need lost leaders or a few margin laggards to satisfy customers’ one-stop-shopping demands… but always revisit those assumptions.
While those lost leaders or margin laggards may have been strategically imperative in the past, the world changes. Those imperatives may be obsolete.
You may already have all the capacity you need.