The Price Is Wrong
The owners of Contextural Design could have sworn they were making money on every unit they sold.
Contextural Design Inc.'s founders certainly knew their oak and pine when it came to producing a 70-item line of attractive furniture for sale to retail stores. The four were babes in the woods, however, when it came to setting up a pricing system in their Raleigh, N.C., plant. This past January, a North Carolina bankruptcy court closed the books on the liquidation of the company's assets -- primarily because of a miscalculation in pricing that went undetected.
Pricing mistakes, of course, are by no means the exclusive domain of greenhorns. Even established companies make blunders, and Big Eight specialists seem powerless to stop them. How come? "Because pricing is not a science," hedges one Deloitte Haskins & Sells practitioner, "it's an art." Indeed, when it comes to how to price, high-priced counsel often is at odds with itself. Perhaps their soundest rule is: "Start where you think you can sell a product and make a profit. If you can't find that price, the bottom line is maybe you shouldn't be in business." As Contextural Design discovered, however, even if you think you have found the right price, fast-growing sales can hide the bad news that your pricing formula is off and you aren't making a profit after all.
When the partners, all in their twenties, formed Contextural Design in the fall of 1977, they reasoned that crafting their own parts would enable them to control not only materials and manufacturing costs, but the quality and integrity of their products as well. So the foursome set up a production line that took in rough lumber by the board foot, and sawed, clamped, glued, tenoned, planed, routed, mortised, and sanded it into unfinished components, which were then shipped to some 800 furniture-in-parts outlets throughout the country.
Given all those steps and the machines and space needed to execute them, how, then, to calculate a price? The partners decided that 50% gross "felt like it would work" not only taking care of overhead, but returning a comfortable net profit as well. So they simply added direct labor and raw materials and multiplied by two. The result led to a credible wholesale price, and for five years, the humble arithmetic showed signs of working. By 1983, revenues were compounding so briskly that the corporation placed #177 on INC.'s 1984 listing of the country's 500 fastest-growing private companies.
But on the company's way to pick up the plaque that commemorates such exhilarating sales growth, something went awry with profitability. The principals had been so busy moving furniture onto the shipping dock that they didn't complete their June 30 year-end statement until mid-November. With the finally finished financials in hand, Contextural Design president and co-founder H. Bruce Sauls headed north to the New York City offices of William Iselin & Co., the C.I.T. Financial Corp. subsidiary that was factoring Contextural Design's mushrooming receivables. Sauls presented the results, which, unfortunately, strongly suggested that Contextural Design's net worth was heading south. "But we feel we have things under control," Sauls reassured the distraught creditor, who was studying a financial statement showing payables of $454,322 versus receivables of $189,025, a 4% pretax loss -- $95,431 on sales of $2,393,090 -- and a net worth whose size had shriveled well under Iselin's lending floor of $100,000. Sauls recalls that the gist of the response was, "Well, we don't think you do."
Factors traditionally purchase accounts receivable outright at a discount and make their profit on collecting the full amount of the invoices. But Contextural Design's receivables already were pledged as collateral to its bank, so, in an unusual arrangement, Iselin took second position on them. The factor had been advancing Contextural Design 80% of its receivables, plus the remaining 20% when the invoices, payable to Iselin, were collected. In return, Contextural Design paid 1.25% of gross sales as commission, plus 2.25% over prime on the average daily balance of funds advanced. By June's close, Contextural Design had run up more than $50,000, or 2% of sales, in factoring charges alone. Iselin immediately trimmed Contextural Design's line of credit to zero. And it insisted on using collections to pay down the outstanding balance, rather than advancing them.
"If the factor had continued to work with us, we could have pulled it out," Sauls says ruefully. "The loss was just a few percentage points." But it is not a lender's nature to view misfortune in relative terms. And not without cause: the next interim statement, six months into fiscal '85, revealed a continuing slide, this time a loss of $88,741, or about 6%.Although, at $1.4 million, sales were up more than 20% from the previous year, the capital-short crew was already three months behind on over $500,000 in payables mostly to lumber brokers, any one of which could blow the whistle.
Contextural Design stayed in business another 13 months, but it was downhill all the way. The company's story is all the more poignant because the balance between making it and losing it was so slim. A cost cut here, a product or two discontinued from the line, certainly a price rise before credit was cut off could have stemmed the slide.
In hindsight, much of the blame for the debacle lay with the company's seat-of-the-pants bookkeeping, which had no provisions for raising warning flags. On the contrary, financing rapid growth through borrowing on receivables concealed the fatal miscalculation in margins that ultimately was Contextural Design's downfall. The problem was, at first it worked. But "it was always a very small margin we ended up with," Sauls remembers. Then, unfortunately, sales began growing rapidly. So rapidly, in fact, that every time one of those advances came in from New York, it felt like the company was raking in big dough.Instead, of course, it was only straining its credit.
