Does Closing Factories Really Improve Profitability?

Spend Matters welcomes another guest post from Pranav Padgaonkar of GEP.

The oft-seen headline “Firm closes factories in effort to revive profitability” seems logical at first glance, especially when the savings from layoffs are highlighted. The stock always reacts positively. But think again – closing factories just makes the firm smaller, not more profitable.

Consider the example of a firm comprising 100 factories producing identical goods and making an identical loss. Closing 20 of these factories reduces not only costs and losses, but also revenues. It leaves the firm 20% smaller but not financially healthier. In fact, a closure itself entails substantial costs and risks, so it could leave the firm smaller and financially worse off.

The prerequisites for a plant closure to improve a company’s financial health are listed below. As we will see, procurement plays a crucial role in ensuring that these prerequisites are met:

Closures must not eliminate customers: The improved profitability comes not from the closure itself, but from the higher utilization of the remaining factories. Thus it is critical that the remaining factories can still cater to existing customers. Any disruption in supply will mean lost customers, but at the same time a sub-optimal supply chain can erode the efficiencies from higher utilization. Procurement and supply chain are critical in ensuring that the hastily established alternative supply chain is both efficient and effective.

Closures must eliminate the highest cost centers: Closing a factory is a painful decision – so it is absolutely critical that the right factory is targeted. Profitability increases when the average cost decreases. Thus factories with the highest costs must be closed. To guide this decision, procurement can provide a granular breakdown of both current and future costs. For example, it would be unwise to close an energy intensive factory, if energy is about to become subsidized or de-regulated in that region. The current cost may be high, but it is likely to drop substantially.

Asset recovery must cover the costs of closure: The key media focus in factory closure is workforce negotiations led by HR. However, there are substantial non-severance costs involved in a closure, which procurement must minimize. These include services such as deconstruction planning, demolition, equipment ramp-down and decommissioning, environmental consulting, waste management, etc. Procurement also drives asset recovery, making the “redeploy versus divest” decision for each asset, based on the demand forecasted in the rest of the organization and the liquidation price from the market.

Closure risks must be mitigated effectively: The factory personnel who execute a closure are paving their own way to termination. Also, the factory deviates from stable processes to go into ramp-down mode. These changes come with inherent risks. Procurement, working with legal, can play a crucial role in ensuring risk transfer where feasible. The entire responsibility (and risk) of environmental cleanup can be transferred to the environmental contractor. Similarly, the demolition should be executed by a third party assuming full responsibility for worker safety.

Thus, procurement plays a crucial role in making sure that the above prerequisites are met and the painful decision of plant closure effectively translates into future profitability.

For more interesting thinking on procurement, visit the GEP Knowledge Portal.

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