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."
