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By The Numbers – Part 1.

January 26, 2010

The agency I’ve been helping out, The Gilligan Group, does advertising and packaging design.

I had a discussion today with the principal, Kevin Gilligan, about how clients react to costs of advertising versus costs of packaging. In his experience, clients tend to look more closely at the costs of packaging than they do at advertising. He said he really didn’t understand why.

During my time in the packaging industry, I’ve seen packaging engineers who spend hours working to shave 1% off the sheet size of a folding carton, to yield a net impact on gross margin of only about 0.1%. It really makes me wonder if this is time and money well spent.

My feeling about this is that advertising and packaging are treated very differently from an accounting perspective.

Packaging is part of the cost of goods, so there is an impact on margins or profitability. Advertising is usually expensed below Gross Margin, and is group in with promotional spending such as off-invoice deals and consumer promotions. (though I’m inclined to think of off-invoice deals should be treated as a deduction from revenue, since they are basically a price concession.)

Personally, I have a strong belief that packaging should be as much considered a promotional expense as it is a cost of goods. There’s no question that packaging is an integral part of the product. However, I argue that packaging is at least as effective as advertising in persuading consumers to purchase a brand.

I’m going to digress a bit from packaging for a moment to illustrate the traditional margin-centric view of profitability vs. an alternative approach.

Either some of the cost of the packaging should be attributed to the promotional portion of the P&L or we need to re-think the accounting model of measuring profitability by margin.

Shortly after I was promoted to brand manager on PINE-SOL liquid cleaner, I was told the finance wizards in our parent company wanted to divest the brand because it was the lowest-margin product in our stable of brands (without giving away specifics, let’s say PINE-SOL contributed a margin in the mid-40’s while the other brands were considerably higher.) and the #3 ranked brand in terms of sales, behind OLD SPICE and BRECK shampoo.

Our controller and I developed a different approach to measuring the profitability of the brands.

PINE-SOL sold through grocery stores and its inventory turned over between 11 and 14 times per year. As a result the amount of inventory we held at any time was between 7.1 and 9.1% of sales. By comparison, OLD SPICE, which had a strong season sales skew, turned inventory over approximately 2 times per year, meaning the inventory we had to carry to support the brand was about 50% of sales.

The grocery industry, at that time, were reliable in paying their bills, so we typically collected on sales of PINE-SOL within 30-45 days. The OLD SPICE brand sold primarily through drug stores and mass merchandisers, who were not as prompt in paying their bills, so receivables typically ran over 90 days. (OLD SPICE was sold on a guaranteed-sale basis, so the retailers were reluctant to settle up until we had taken back excess unsold merchandise, which was one reason for the longer receivables term.)

When we evaluated the brands on the basis of return on capital employed (essentially economic value added) the smaller inventory investment and smaller receivables outstanding on PINE-SOL made the denominator small enough that, when compared to OLD SPICE, the lower-margin PINE-SOL actually proved to be not just the more profitable brand, but the MOST profitable brand in the company.

The net of this was that, when we presented this to the finance wizards in head office, they were amazed enough to reverse their recommendation to divest the brand and, in fact, recommended investment spending in PINE-SOL (primarily increased advertising) to build the brand. Sales doubled in two years.

What does this look like when we put it into action?

On the negative side, downgrading packaging to cut costs could have adverse impact on consumer satisfaction with the product, which could erode sales and reduce stock turns. Perhaps, for example, taking a liner out of a cap could allow a higher percentage of leakers that grocery shoppers would avoid purchasing. Another example could be converting to a lower grade of paperboard for a folding carton, which could result in the flaps tearing instead of lifting open and creating some consumer dissatisfaction that results in fewer repeat purchases.

On the plus side, investing in packaging innovations could make the product easier for consumer to use or overcome some important objection to purchasing the product. One of the factors contributing to the growth of PINE-SOL was conversion from glass to plastic packaging. As noted in my previous post, this made consumers feel the product was safer to use in bathrooms, which had been the major objection. Another example is Sherwin-Williams’ DUTCH BOY paint, who introduced a wide-mouth plastic jug with a twist-off cap that was easier to open and pour than the previous metal paint cans.

I’m going to be arguing for the plus side, so watch for more posts, and please feel free to comment.

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