Australian manufacturing under siege

Most of us recognise that manufacturing in Australia has long been problematic – the cost of labour, small domestic market size and our distance from larger markets (among other things) all create headwinds for our manufacturers.

For years, no-one cared much about the sector. Governments of all persuasions provided little support, the R&D tax incentive and Export Market Development Grant aside. The populous moaned a little but ultimately voted with their wallets to support cheap imports. Proponents of the global economy (myself included) thought this was the way it should be, this was the market efficiently allocating scarce resources.

The COVID pandemic suddenly changed the sentiment. It was no longer a question of pure economics. Dependability suddenly had a seat at the table. We became interested in the strategic importance of our ability to manufacture. Buzzwords like ‘onshoring’ and ‘reshoring’ got a run in the press, especially in relation to so-called ‘critical industries’ – medical supplies and defence among those.

PROBLEM 1
IT’S GETTING HARDER TO MAKE A PROFIT

However, trading conditions have only become tougher. The cost of inputs has risen substantially. Cash has tightened up. Make no mistake, these times will test your management. It’s the job of management to make decisions, to direct action and to deliver a result. What will you do?

PRICES – Think energy prices, labour, freight, materials, rents that are often pegged to CPI and interest rates too. All while the Aussie dollar has moved against importers of raw materials. In some instances, conscious decisions have also been taken to accept higher prices for greater certainty of supply.  So, in an environment of higher input costs, it makes sense that your prices have to increase in order to maintain margins. That means that you need to sell well.

4 REASONS MANUFACTURERS LOSE OUT ON PRICES

Reason #1: Some manufacturers are contractually bound to supply their product at a particular price. Seek to include triggers for a price increase at the time you are negotiating the contract and be wary of locking yourself in to long-term arrangements if you cannot also manage the cost of your inputs.

Reason #2: Some manufacturers lack the confidence to push through a price increase. This is generally borne of fear – the fear that they will lose the customer. That fear may reside with the sales team whose KPIs demand a certain result. Organisations can support their sales team to overcome this. For example, the CFO can prepare an analysis that shows how many customers (or units of production) would need to be lost before the organisation was worse off after the price increase. Or perhaps KPIs can be modified to bring balance between long-term and short-term objectives. For their part, CFOs need to understand the dynamics of the market they operate in. How much power does the manufacturer actually have? Australia is a land of many oligopolies – in that environment, you may have more pricing power that you first think.

Reason #3: Some manufacturers lack negotiating skills. For years, their sales teams have been order takers and not order makers. That probably reflects their view that they have little power at the negotiating table. Like anything else, if you don’t exercise the skill, you will lose it. If you’ve got time on your side, negotiating skills can be taught. However, you may need to be prepared to shake up the sales team to inject some better negotiating skills sooner.

Reason #4: Manufacturers may be slow to react, slow to make decisions. The harsh truth is that this is essentially poor management.  Again, it’s driven by fear. In a world of imperfect information, the likelihood of making a bad decision is increased. So, we procrastinate, we make no decision at all. But if prices hold steady while the cost of inputs increase, it’s profits that suffer. How long can you sustain that?

And/or your cost of manufacture has to come down, because a failure to maintain (or even improve) margins is likely to give rise to a tough discussion with shareholders. Either way, you are going to need to get good at having crucial conversations! The push-back you can expect from customers relates to efficiency. Expect your customers to interrogate you about the steps you have taken, and are continuing to take, to create efficiencies in your operation in order to apply downward pressure on price.

WHY YOU SHOULD WELCOME THE EFFICIENCY DISCUSSION

Efficiency is code for ‘cost saving’. If attained without any negative impact to effectiveness – efficiency is good for everyone. For you, the customer and ultimately, the consumer. If you had to choose between the two, and assuming you don’t give up all of the efficiencies to your customer, it’s arguably a better outcome than a price increase. So, notwithstanding the difficulties associated with making and maintaining changes to your processes, we argue that you should welcome the efficiency discussion.

The opportunity to study the components of the costs your business incurs and how it is reflected in the products you make is just that, an opportunity but one that can get lost in the daily grind. An efficient business is a competitive business. It all begins with understanding your costs and taking a collaborative approach.

Be on the lookout for ‘win-wins’. For example, faced with the prospect of a price increase, your customer might now be prepared to budge on the number of units they order, making your production run more efficient. Perhaps they are prepared to budge on the frequency of deliveries, or the number of delivery locations making your freight spend more efficient. Perhaps they are prepared to rationalise SKUs or reconsider product composition (think of the lower profile caps on soft drink bottles – it has no impact on the contents of the bottle but is an obvious cost saving).

Having sharpened your skills in that arena, it’s time to take a look at where it all begins. The easiest route to keeping your costs down is to buy well. In this relationship, you are the customer. So, this discussion is a mirror image of your discussions with your own customers. Of course, your suppliers are likely to be experiencing cost pressures too, so don’t make it all about cost. Once again, be on the lookout for those win-wins.

PROBLEM 2
IT’S GETTING HARDER TO FUND YOUR OPERATION

Shrinking margins impact funding in two obvious ways. First, the ability to self-generate cash through profitable trading is by definition, being hampered.

The second, flow-on effect is that lenders – another traditional source of cash and who may already be nervous about the sector – may become nervous about your particular business and your ability to manage the business. This is only exacerbated by rising interest rates as interest cover ratios swing against you.

Meanwhile, supply chain pressures – whilst they may now be easing – have sucked up cash. The move from just-in-time to just-in-case (beautifully captured in this great article in the December 21, 2021 edition of the Australian Financial Review means that cash that was once sitting in your bank account, is now sitting on racks in the warehouse. So, how do you fund your operation in this environment?

PROBLEM 3
THE CAPITAL CHALLENGE

Recapping the situation then, you have more working capital (and less undrawn facilities) invested than ever before. You have skinnier margins and that reduces the rate of cash accretion in your business. All of this threatens your growth. Moreover, you are under pressure to find efficiencies and that may require capex. What are you going to do?

Assuming anything needs to change, we think manufacturers have two choices. Access more capital to ensure they are properly funded or downsize their operation to better fit the amount of capital they have. Get more cash or get smaller. Your call based on your organisation’s risk appetite, its ambition and circumstances including but not limited to your investment horizon.

4 PLACES TO GET MORE CASH?

Option #1: The Holy Grail is retained profits. That is, cash you have accumulated from operations. This should always be your first thought because it’s the sign of a healthy business. However, noting current operating conditions, it may have become harder than before.  

Option #2: Lenders. Despite rising interest rates, borrowed funds remain cheaper (and on that measure more attractive) than equity. Anecdotally though, it is getting harder to borrow funds from traditional sources and of course, borrowing increases your risk profile. So, go in with your eyes open. As an alternative, you could consider refinancing existing facilities, to reduce the pay-down (amortisation) profile of your borrowed funds, allowing you to retain your cash for longer.

Option #3: Realisation of assets. In a perfect world, this would be your inventory holding. In reality, it could be surplus land, plant & equipment, motor vehicles etc or even a non-core business unit.

Option #4: Investors. The most obvious place to start is your current shareholder group. If they see a bright future, notwithstanding the current circumstance, they may well be prepared to go again. Anecdotally, we are hearing there are other players, opportunistically eyeing Australian manufacturers. Getting the right price, and the ‘right money’ (the type of investor that is well matched to your business) will be key.

If you go looking for cash from external sources, it’s important to think ahead. In other words, ask for the amount of money you need to execute your 3-year plan rather than a shorter-term plan. This implies a rethink of all things from strategy down and we think that’s appropriate anyway, given the very different economic circumstances of today.

So, what of this idea that you might actually choose to get smaller? It flies in the face of assumption, that is, that bigger is better. And most people default to the pursuit of top line growth. It’s only when you think that through that your focus becomes profit and you start to recognise that it’s eminently possible to have less turnover but end up being more profitable. What if you could delete marginal SKUs? What if that meant no overtime or weekend rates? What if that meant you don’t have to expand the warehouse to cope with a higher level of inventory? What if it helped you to simplify what you do?

Like growth, a deliberate endeavour to get smaller should be properly planned and thought through. Suppliers, customers and staff are all depending on you.

Beyond those human considerations, it’s important to map the consequences of your decisions – if you pull this piece of string, what happens down the line? For example, does a decision to delete a given SKU mean that you miss bulk rates on some of the inputs, meaning that your cost of sales increases on other SKUs? Or are some of your costs locked in for a period, meaning that the benefits of getting smaller won’t be felt immediately?

Could you kill two birds with the one stone? Perhaps getting smaller by divestment of a non-core business unit, which might also put some cash in your pockets? Obviously, that type of decision shouldn’t be taken lightly. It’s important to consider all of the ramifications. Start with understanding why the business owns this non-core business asset in the first place. Someone, at some time, thought it was a good idea. Has that changed so significantly that it is no longer a good idea? You should also consider timing. Asset values are under pressure due to the cost of capital, so you might not attract top dollar right now. That being so, how does this option to access capital rank among all others?

So, as always with manufacturing, there’s plenty to contemplate. Out of the maelstrom of possibilities, we think the priority effort areas are buying well and selling well. Those two things protect your margin and in doing so, contribute to maintaining or improving your bottom line. And in our judgement – by comparison with transforming what happens on the factory floor – it involves less people, less processes and is relatively easier.

If you would like to discuss your operation, please email info@bridgepointgroup.com.au or call us on 1300 656 141.

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Neil Parker

MANAGING DIRECTOR

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