The Price Is Wrong
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.
Theoretically, if you keep borrowing on sales and sales keep increasing, you can go on forever without entering a ledger. What was wrong with that notion practically speaking, Sauls suspected, uneasily, was that true costs might be exceeding sales. Something told him that could not go on forever. And a slow unfolding of events proved him right: the actual labor costs in the pricing formula had been miscalculated; and overhead, earlier ignored, was in fact a major expense.
The dawning occurred, Sauls reports, when Coopers & Lybrand prepared a review of fiscal 1983. In order to estimate how much dollar value was on the floor in inventory, the firm based its calculations on total actual costs divided by a percentage of each item's sales price. In this way, inventory in June 1983 was calculated to be $246,490 -- a figure that to Sauls was suspicious. "They said there was so much inventory that we had to liquidate some of it. I kept telling them we can't possibly have that much."
Nonetheless, the figure stood. Indeed, the plant was so busy that the same evaluation was allowed in the interim statement of December 31 as well. Though that six-month period booked operating income of $74,752, Sauls uneasily undertook a physical inventory. Sure enough, a 40% overstatement -- more than $100,000 -- was revealed, and there went 1984's first-half earnings.
It was time to throw the pants in the hamper and get a computer. Within a few months, Sauls had calculated that his allocation for overhead should have amounted to $1.50 for every $1 of actual labor. Contextural Design wasn't even close to covering the costs the computer was coming up with. "Well," Sauls dismally reflected on the company's growth, "if overhead on those workers is one-and-a-half times labor, we are losing money -- and we're about to lose a lot more."
Not only was the overhead underestimated, but actual labor figures in the pricing formula were unwittingly distorted by Contextural Design's owner-officers. They dashed about the factory floor performing various tasks to determine how to bill the labor involved, but ignored such integral chores as setting up the machinery, moving the parts from one work-station to the next, and so on. While the costing calculations indicated that five parts could be completed per minute, in practice, the 86 employees they paid to execute the same tasks were completing only two or three. The computer's analysis showed that not only were actual labor costs off per Contextural Design product, but by almost $17 per $100 of sales over industry averages. And if that wasn't bad enough, no one had yet stopped long enough to calculate accurately materials waste in working the hardwood lumber. Also eating into gross margins were raw-materials costs, Sauls discovered, that ran some 45% of total sales -- about 20 points more than the industry norm. But the real problem, Sauls says, lay not in production efficiency but in pricing. "There never was a market analysis of price, never any consideration of what the market would bear. That's what was so crazy."
A modest price rise as late as 1983 might have saved the company. But, Sauls says, whenever he broached the subject from the sales side, his partners in production feared that their untested market wouldn't support one. "The normal course if for sales to come to manufacturing and say, 'Listen, you've got to get the thing in at this price,' "Sauls complains in retrospective wonder. "But I was saying, 'We can sell it at 5% more.' They argued that it would cut the volume. Their attitude was, everything has to be fine. They were too busy getting the stuff out the door to bother with details."
Subsequent "tests," however, hinted that the market would have supported an increase. For example, in 1984, Contextural Design had to reduce the thickness of some of its parts due to increased oak costs, yet sales volume held. And when the price of a popular pine computer stand finally was raised from $48 to $52, orders inexplicably increased.
By February 1985, Sauls's three partners had agreed to an increase that raised prices by as much as 20% on Contextural Design's 41 remaining items. On April 5, Sauls bought out his partners, sold off most of his manufacturing facilities, and trimmed employment to 14. On June 19, however, still facing a critical working-capital deficit, Contextural Design formally filed for protection.
Today Sauls is one of seven modestly paid employees of Delta Design Inc., the company that bought Contextural Design's assets. Gross margins are an unaspiring 35%. Accounting and bookkeeping have been computerized. Each stage of work-in-process is accounted for as a separate product number. Overhead is charged at 1.5 times labor. Break-even volume is down to about $100,000 a month from the $244,000 needed at Contextural Design even after its February price increase. "We would like to see steady, proven profits for allof 1986," says vice-president of design and marketing Sauls, in proper managerial cadence, "before undertaking the kind of growth that placed us on the 1984 INC. 500."