Matrix-Based Management, Part II: Operations and Support

The Five Point Matrix measures past, present, and future drivers of productivity. In a healthy business, all parts work in harmony to achieve the objectives of the Corporate Mission Statement. The Matrix is designed to force “alignment” in a business—i.e., harmony among its component parts. Each part supports the whole. You can use the Matrix to evaluate how healthy your business is now or how a change in one area could affect other parts of the business.

The “drivers” of productivity are designed to measure success within the organization. We will look at some common drivers for the jewelry industry, but others may be more specific to your business.

The Matrix consists of six parts: The Corporate Mission Statement, which sits in the center of the Matrix, and five components: Financial, Operations and Support, Sales and Marketing, Training and Education, and Social Mission.

This month, we’ll look at the Operations and Support component, relying once again on three years of data from the Jewelers of America (JA) Cost of Doing Business Survey. Our sample company has the following mission:

“This Company exists to sell quality jewelry at a fair price so that we can become a business that is financially stable, even prosperous; one that has an excellent reputation for integrity and humanity and is known as a great place to work; one that rewards all stakeholders and encourages investors to continue to support this company.”

Operations and Support. This area comprises everything that supports the other components, such as all systems that make the business run well (or not so well). It includes the “systems” necessary to measure the criteria for evaluating the other areas; getting the information for evaluating the other areas; and basics such as data entry, store maintenance, shipping and receiving, inventory control, special-orders processing, quality control, hiring, and personnel files. In most stores, this job is performed in the back office.

The most important part of Operations and Support involves the ability to measure information in the other categories. Without the proper business organization, you can’t know how well you’re doing, apart from an annual tax return prepared by a CPA. Besides, the information an accountant needs to prepare a tax return is not always the same information you need to run your business profitably.

Therefore, the Operations component serves as the “hinge,” because the other drivers require accurate measurements, which come from the operations component.

This component also affects the quality of life of a small-business owner-operator. A well-organized store helps the owner enjoy a peaceful personal life. A disorganized store forces the owner to react to each new “crisis” (whether or not it’s truly important), diminishing quality of life. If operational systems aren’t healthy, the whole business will be out of harmony.

Q&A for O&S. The Operations and Support area addresses four parts of the mission statement: “Sell quality jewelry,” “excellent reputation,” “fair value,” and “financially stable.”

Here are the key questions to ask:

  • Do we have the systems needed to measure the other components?

  • What areas of our store are most profitable?

  • Are we spending more or less to operate our store?

  • What are we spending to drive traffic into our store?

  • Are we earning enough from each sale to operate our store?

  • Where did our earnings go?

  • What measurements will we examine?

Perhaps the most important question is: Do we have a system to accurately measure the things we should know about our business? Here’s what every business owner must know about his or her business:

  • average retail sale, average mark-up percentage, gross profit in dollars, and contribution dollars;

  • profit centers within our store by jewelry category, by salesperson, and by supplier;

  • rent and operating per square foot;

  • rent and advertising as a percentage of sales;

  • gross profit analysis;

  • balance sheet analysis.

Measuring up. Understanding exactly what’s going on within a business is crucial. The Operations and Support component gathers this information and disseminates it throughout the company. If you know how profitable an area is, you can better make decisions regarding continuing it, expanding it, or simply putting up with the headaches that can come with certain parts of the operation.

While many have used manual systems to gather and measure information, I believe a good computer system is now a requirement for sustained profitability. I use the ARMS program, but many systems can measure information. However, you should be careful: Too much data without interpretation is as dangerous as not enough data. The solution is not a computer program that spits out reams of numbers, but one that helps condense the numbers to easily understood ratios that can guide decision making.

Profit centers. Look at these areas on a regular basis to determine if you’re meeting the goals set forth in your mission. “Profit centers” can include departments (jewelry categories), salespeople, suppliers, and—in the case of multiple locations—stores.

Regarding finances, we measure the daily cash taken in, but we also look at the number of special orders and pending layaways. This tells us not only about present cash flow but also about future cash flow. For inventory and sales, we measure average retail sale, quantity of sales, average markup percentage, gross profit in dollars, return on investment, and inventory turn. We also look at the average retail price of existing inventory to predict whether future retail sales will increase or decrease.

If corrective action is needed, we might think about restocking with items at higher or lower price points to stay within sales goals. Measure these things for each profit center, and make sure the costs are matched up to each profit center in order to evaluate it more accurately. Because most of the direct costs are cost of goods, pay special attention to the gross profit in each center.

Accountants often rely on “cost accounting,” which distributes the shared costs of each activity based upon a formula. Management accounting more accurately relies on “contribution costing” which looks at the dollar contribution of each activity to the “shared costs.” An example of “shared costs” would be the owner’s salary, the bookkeeper’s pay, or the rent for the main office (or portion of rent attributed to the office, if it’s within a retail location). These often fall under the term “administrative expenses” but should not be limited solely to that. Rather than rely on an accounting formula to allocate an expense like an owner’s salary to the different profit centers, we look at each profit center’s contribution in dollars toward the owner’s salary.

The proper establishment of profit centers enables us to answer the question, “What parts of our store are most profitable?” This raises a question regarding which parts receive the highest markups. Remember, you can never pay your rent with a markup percentage, but you can pay it with profit dollars—and dollars are more important to watch than markup. (Remember, however, that you can’t get those dollars without a good markup!)

Using the JA Cost of Doing Business Survey, let’s look at categories as the basis of our analysis.

Year 1 Year 2 Year 3
Total sales $570,685 $715,781 $696,241
Total gross profit $273,929 $339,281 $343,994
Sales of diamonds $240,828 $335,701 $330,714
Sales of karat gold $70,194 $76,588 $77,283
Sales from appraisals $2,853 $2,863 $3,481
Gross profit from diamonds and diamond Jewelry $111,737 $156,487 $151,598
Gross profit from karat gold jewelry $37,414 $40,745 $41,810
Gross profit from appraisals $2,065 $2,496 $2,898
Percent of sales from diamonds 42% 47% 47%
Percent of sales from karat gold 26% 23% 22%
Percent of sales from appraisals 0.5% 0.4% 0.5%
Percent of profit from diamonds 41% 46% 44%
Percent of profit from karat gold 14% 12% 12%
Percent of profit from appraisals 0.8% 0.7% 0.8%

In the above analysis, appraisals have the highest markup but contribute only a fraction of a percent in terms of dollars. Diamonds have become increasingly more important to overall sales and—more importantly—to profit, while gold has become less important. The next step is to determine how much space, training, and open-to-buy money has been allocated to diamonds. In this example, if appraisals take more than 1% of the owner’s time, they become highly unprofitable. (We’ll address this appraisal dilemma in future articles.)

Operating maintenance and rent. The next area to look at involves the maintenance of the store. Are we spending more or less each year to operate our store? Again, let’s return to the Cost of Doing Business Survey.

Operating Year 1 Year 2 Year 3
Rent per foot $16.41 $21 $19.60
Maintenance per foot $140 $175 $169
Total operating expenses $233,981 $295,618 $287,547

Each year, it’s costing more money to operate the store. To the extent that these costs vary with revenues, the store is fine. If these expenses become fixed, the store could be in trouble if sales suddenly drop. I believe in having a rent expense that is fixed and a payroll that is more variable—i.e., increasing and decreasing with sales. Each store may be different, but review the composition of expenses annually to keep expenses from escalating faster than sales.

Traffic drivers. The standard ratio for sales to combined advertising and rent is 10%. Some locations cost more to rent because they’re high-traffic areas. Locations with less traffic cost less to rent but require extra advertising to drive traffic.

Rent and advertising Year 1 Year 2 Year 3
Rent $26,252 $33,641 $33,419
Advertising $22,251 $26,483 $27,849
Combined total $48,503 $60,124 $61,268
Standard 10% of sales $57,000 71,500 69,600
Percent of sales 8.50% 8.30% 8.80%

In this case, an increase in advertising in year two increased sales; in year three, it did not. This store could afford another $8,600 in advertising—a 31% increase. But even if not all of the advertising is effective, the portion that is effective should make a difference. (As J.C. Penney said, “Only 50% of my ad budget works. I just can’t figure out which 50%.”) Here, an increase in “effective” advertising would cost $4,300, and it could be useful.

Incoming vs. outgoing. Are we earning enough to operate the store? Every sale consists of two numbers: the cost of sales and the gross profit. The cost of the product is the supplier’s portion and should be used to pay the supplier in the case of special orders or memos, or reordered from the supplier to replace the inventory asset. The gross profit is what is available to operate the store. “Flipping” a diamond—moving it quickly by cutting the price—is not the most efficient way of selling, because then a higher portion of the sale goes to the supplier, leaving less money for operations. Too many “flips,” and a store can get into trouble quickly. Suppliers often tell the tale of the retailer who made a big sale yet failed to pay the bill. “Flipping” is usually the reason for this problem.

Another way to look at any given store is the size of the operation as a function of operating expenses rather than gross sales. Jewelers often place too much emphasis on gross sales and not enough on gross profit, which can be misleading. For example, a store making $1.5 million in sales with a 200% markup has $1 million available for operations. A store doing $2 million in sales with a markup of 40% has only $570,000 for operations. While the second store does more volume, the first store is almost double in “size” as an entity.

Sales Year 1 Year 2 Year 3
Sales $570,685 $715,780 $696,241
Cost of sales supplier portion $296,756 $376,500 $352,994
Gross profit operating portion $273,929 $339,280 $343,247

In the above example, the supplier benefited more from the sale than did the retailer, leaving the store less money to support operations. (If the supplier did more work to make the sale—for example, through advertising of brands—then they may deserve this.) Generally, most stores do not generate enough profit from what they have sold to pay for what they have not sold and to operate the business.

Who benefits from the sales? At the end of each year, this store had net income that was subject to both state and federal income taxes. Often, a small-business owner will complain that he had a profit on paper, but not in his pocket. Where did this store’s profits go—and whom did they benefit?

Profit and cash Year 1 Year 2 Year 3
End-of-year profit $39,948 $43,662 $42,471
End-of-year cash $31,387 $39,369 $38,990
Theoretical cash accummulated from profit $71,335 $110,704 $149,694

After three years of profit, the store should have accumulated sufficient cash to pay the taxes and invest in a nice retirement fund for the owner, or at least provide a cash reserve. But by year three, the store had only about $39,000 in the bank instead of $149,000. Where did this money go?

Inventory Year 1 Year 2 Year 3
Inventory $461,685 $624,159 $629,401
Accounts payable $129,545 $187,534 $199,124
Net inventory purchased $332,140 $436,625 $149,694
Increased inventory $104,485 $(6348)

The bulk of the cash was used to buy additional inventory, and that inventory was paid for from the profit of the business. In this example, the owner received an extra $8,000 in cash at year-end, and the supplier received an extra $104,000 at year-end. The owner is buying inventory faster than he can sell it.

Thus, the supplier took the greater portion of each sale as well as the greater portion of end-of-year profit/cash.

Small adjustments, big difference. What about “high-profit stores” from the survey?

Sales Year 1 Year 2 Year 3
High-profit stores sales $570,685 $715,780 $696,241
Cost of sales suppliers portion $280,477 $370,058 $343,943
Gross profit operating portion $290,477 $345,722 $352,297
Their markup 2.03 1.93 2.02
Our markup 1.92 1.90 1.97

The difference between the “high-profit store” and our store is just a few percentage points in markup. An item that costs $300 will sell for $591 in our store and $606 in theirs. Is $15 on a $600 sale enough to lose the sale? A small adjustment can make all the difference.

Conclusions. Operationally, this store must have the information to evaluate average retail sale, average retail price of inventory, and gross profit by profit center. It must focus more on profit centers like diamond jewelry categories, which generate more profit than less profitable centers like appraisals. In some cases, certain profit centers should be eliminated. This store should review current expenses that have increased faster than sales; some of these expenses should be converted to variable, while others should be converted to fixed. At the same time, the store appears to be underspending in advertising and could increase that budget by $8,300.

One of the biggest problems faced by retailers is lack of sustained profitability. Currently, mom-and-pop retailers like those in this survey are decreasing in quantity to the tune of 500 to 600 units per year over the last five years. A little extra profit could make all the difference for these stores. In this example, the “high-profit stores” were able to attain an extra $15 (on average) for a $600 purchase. To achieve the net profit goal of $60,000 per year that we set in our previous article (see “Matrix-Based Management, Part I,” JCK, June 2003, p. 140), the store must begin to sell with more profit. It will require some discipline to achieve this. However, a disciplined profit strategy managed within the Operations component could save many of these stores.

The next article in this series will look at the Sales and Marketing component.