October 4, 2016
In Part I of our series on the semiconductor and high-tech OEM industry, I provided an overview of the recent deal activity that is currently sourcing double-digit growth for some companies. During the merger, the effect of consolidation and reduction on cost structures in the initial years can be substantial, but also represent tremendous opportunity for additional levers affecting a company’s operating profit.
To see exactly how these new levers impact profit, let’s start with the standard profit equation for a semiconductor company.
- Lever 1: Price — The price you are able to command for your product in the marketplace
- Lever 2: Volume — Number of units
- Lever 3: COGS — Cost of the revenue (allocated as one line-item for both the fixed and variable costs)
- Lever 4: SG&A — Selling General and Administrative Expenses (includes R&D Expense in our example)
For the sake of our analysis, we will take two examples of semiconductor companies with equal revenue and see the effect of a 1% improvement in operating margin on each of the four levers.
Company A is doing fairly well at 60% gross margin and has a good control over COGS.
- Revenue: $1B
- COGS: $400M (40% of revenue)
- SGA: $400M (40% of revenue)
- Operating Margin: $200M
Company B is facing headwinds at 35% gross margin and has room to improve COGS further.
- Revenue: $1B
- COGS: $650M (65% of revenue)
- SGA: $300M (30% of revenue)
- Operating Margin: $50M
After applying the 1% improvement to each lever, the analysis yields the following results:
Here we see that the 1% improvement in the COGS and SG&A expenses results in 2% incremental operating margin, while a similar increase in volume results in 3% incremental operating margin. The latter could be counterintuitive since B2B negotiated selling environments often make it difficult to ask for an increase in volume without giving some concession in price. Finally, a 1% improvement in price (assuming volume is constant) results in a 5% incremental operating margin improvement, which translates to roughly 80 basis points improvement in absolute terms—by far the biggest impact.
Here we see that the 1% improvement in COGS results in 13% incremental operating margin. The same improvement in the SG&A expenses results in 6% incremental operating margin, while a 1% increase in volume results in 7% incremental operating margin. Finally, a 1% improvement in price (assuming volume is constant) results in 20% incremental operating margin, which translates to approximately 95 basis points improvement in absolute terms.
As you can see from our analysis, the slightest shifts in pricing can be the fastest and most effective ways to improve profits. A 1% improvement in price can range between 5% to 20% in incremental operating margin or 80 to 95 basis points for a typical semiconductor company.
In the semiconductor industry where price erosion is common due to rapid product innovation cycles, the desired state of profitability can be achieved by optimizing pricing for each deal and customer using segments that already exist within the industry. The analysis outlined above lays out a foundational business case for a pricing project, which further includes implementing processes, tools, and people.
In Part III of our foray into the semiconductor and high-tech OEM industry, we will look at a newly merged company can achieve pricing effectiveness and increase sales efficiency. Stay tuned!