QUESTION
- Eric, I noticed that the Gross contribution is low in the forth quarter compared to the forth quarter of 2010. The cost of goods for the forth quarter of 2011 are so high. Can you explain that? Thanks.
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ANSWER
Two things: one easy, and the other a bit more involved.
The easy one is that there was a unique supplier recovery (claw back) of certain cost elements in Q4 2010 that would not be repeatable on a regular basis (and placed the 2010 Q4 cost-of-goods-sold (COGS) below the 2010 annual average). But there is also an additional factor.
In 2011 we introduced quality improvements that have not yet been deployed on a large scale, that are being amortized on more frequent small production runs (rather than fewer large production runs).
Two examples of the quality improvements are a special effects label for better shelf presence and a special technical treatment of the bottle to diminish/eliminate “panelling” (denting) of bottles that is a partial vaccum created through the effect of the product on the recyclable plastic. As we have been reducing our 504 capital draw from the markets, we have been making smaller individual production runs. Also, in 2011 vs 2010, we had more production related freight costs of moving around manufacturing inputs and outputs (parts and finished product) pending completion of additional warehouse space attached to the production facility. That specific factor is being diminished in 2012 as the production facility holds more at hand, rather than receiving “as needed”.
When we carry out our new re-financing, one of the “use of funds” elements is to return to larger production runs and holding more inventory on hand so that all production elements are more efficient. Also, we will then proceed with a new resin for the bottle that requires no special treatment but does need completion of a production mold associated with minimum volumes. There is quite a saving when ordering labels 200,000 at a time instead of 5,000 per run, for example. The cost efficiencies that I am describing can easily account for 10 percentage points of margin, or more.
Bottom line: We benefited in Q4 2010 from a special opportunity on costing, and subsequently we increased our packaging quality in 2011 over 2010, but have not been able to amortize the improved items over large runs yet. A high-res picture of one version of the new special effects label effect is shown here. The earlier version was a flat paper effect. The label can be thought of as one of the most important aspects of advertising. With the substantial reduction in conventional marketing spend in 2011, there was a savings available to put back into the product itself. However, according to generally accepted accounting principles, that investment in the upgraded label as an ad appears in the production COGS, rather than in advertising/marketing.
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