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Business Case Study - Cost Accounting I Implosion at Ecomom Ecomom.

Small startup internet retail company selling earth friendly mom and maternity products including food, toys, apparel, and other baby related items. Four years of history, 2011 revenue just over $1 million. Philip Prentiss. That's me. 42 year old single guy with a freshly minted CPA I had just received after 5 years of night school. I needed a job, and searching for a job sucks. After 6 rounds of interviews with every senior member of the Ecomom team, I got the nod for company controller, base salary $105,000 with another $100,000 of stock options. Reporting direct to CEO. Was I totally and completely thrilled? You bet. The CEO and founder, Jody Sherman, instructed me to show on my first day of work at the end of October 2012 at the Las Vegas headquarters. There was no previous controller or finance department; as with many small companies Ecomom had traditionally be run on the basis of the bank statements. Payroll and tax were handled by a third party bookkeeper who also received invoices and prepared all checks for Jody's signature. This system had worked relatively well when the company was small, but now with the enormous growth in size the number of invoices had reached well over one hundred a month, too many for a part time outside bookkeeper to handle. Things were starting to get out of control. Ecomom had received a large number of delinquent notices for missed payments and that was my first assignment: clean up Accounts Payable. In spite of the complete absence of established procedures, the financial processes of the company were actually in pretty good shape. All customers paid by credit card which was directly deposited into our bank accounts and so there were no accounts receivable. Payroll and tax were accurate and fairly efficient. No Balance Sheet or Statement of Cash flows had ever been prepared, but the Income Statement was quite presentable, and more importantly reconciled accurately to the bank account statements. The one big weakness was lack of matching between purchase orders, bills of lading, and invoices. In the past, either Jody or his co founder would initiate an order, and then since Jody signed all the checks, he would simply remember when the bill came in whether it had been received and whether to pay it. This worked well at $50,000 worth of cogs a month, but at triple the volume wasn't working anymore. Fortunately the solution to this problem has been known for centuries. I instructed purchasing to print each Purchase Order, staple it to the Bill of Lading when received, hand it to me, then I would staple that to the Invoice a cut the check. All payments paid on time and no double payments. The operations team was extremely excellent, and pointed out that my plan would kill a lot of trees in an eco antagonistic fashion, and that our computer system was more than capable of accomplishing this entire task electronically. Morale was high, the staff were treated well and many came from big companies with extensive operational experience. I had no more to say than "can you fix everything up?" while waving my hands vaguely and in less than two weeks the procedures were in place. The employees already knew how to handle inventory and non

inventory invoices and delivered tidy expense reports with collated receipts without prompting. After a month on the job I knew I was going to look like a hero. The honeymoon lasted that whole month. The October Income Statement looked like this: ($000's) Revenue: 322 Cogs: 173 Gross Margin: 46% Selling: 288 G&A: 102 Operations: 169 IT: 87 Cust Service: 24 Net Profit (Loss): (548) A half million dollar loss wasn't great, but the company just received $4.8 million in financing the previous month and a number of selling and operational expenses were due to one time website development fees. More importantly, black Friday was just around the corner. We anticipated sales of over $1 million for November and without the one time costs there seemed an outside chance we might actually reach the break even point. I loved coming in to work and the staff buzzed happily about the upcoming holidays, vacations, and the holiday party. A few notes on the financial and management structure might be in order at this point. Historically each of the 5 expense line items corresponded to each of the 5 major players in the company. The VP of Marketing approved all Selling expenses and the VP of Operations approved the Operations line item. Jody looked over G&A while IT and Customer Service were run by the final two managers. Jody left each manager with an enormous amount of freedom. He seemed to review major spending initiatives quickly and efficiently and smaller expenses such as travel not at all. Instantly I searched for abuse and waste, for bloated travel and expense reports and questionable invoices, but there were none. Everyone was honest. At the local level the structure was excellent. On a strategic level, however, the story was different. Jody had taken an enormous gamble in a very critical way, a gamble that was invisible to me at the time. Our infrastructure was built for size. We could easily have handled a million dollars of volume a month, probably even ten million. The company had another co founder plus four VPs who outranked me and were compensated proportionately. Next year's target was $10 million in sales and $30 million the year after that, and the VPs followed Jody's lead. While headquarters was in Vegas and San Francisco, our third party shipper operated out of Los Angeles at any volume within 24 hours. First class service, first class price. The IT and Operations group came from a blue chip background based in Virginia, and it was more efficient for them to set up a satellite office there. People Fund, one of our backers, had offices in Guatemala and parts of our marketing fit naturally right next

to them. And there were an army of web design and computer consultants. Payroll for October was $115k, consulting fees for October were $156k. Perhaps October was a fluke? No. Consulting fees turned out to be constant and stable as salary and wages. Each decision made sense for its own reason, but the sum total of individually optimized decisions spawned a behemoth ... a very expensive behemoth. If the sales volume caught up to the size of the infrastructure, this gamble would make everyone at Ecomom very wealthy indeed. November started out well and sales tracked towards the million dollar mark. Marketing revved the engine for Black Friday, the biggest sales day of the year, and we watched sales numbers by the hour. Sales rang the fire bell at every hundred orders and everyone clapped. Sometimes, when a dream dies, it dies all at once, killed in an instant by a meteor from outer space. But in business that rarely happens, and usually the dream dies bit by bit, piece by piece, as each of the chances for success slip away. Black Friday was indeed the best sales day in the history of the company, but simultaneously I would guess that the possibility of spectacular failure first entered Jody's mind. Jody had several heated discussions with the head of marketing, almost always along the lines of: Jody: What are you doing? Where is the money? VP Marketing: We're on track to hit a million dollars. Sales are great. Jody: But where's the money? I'm not seeing the money in our bank. VP Marketing: Marketing is on track to over deliver. November's Income Statement looked like this: ($000's) Revenue: 1089 Cogs: 548 Gross Margin: 50% Selling: 849 G&A: 126 Operations: 334 IT: 65 Cust Service: 30 Net Profit (Loss): (864) Our revenue had indeed surpassed a million dollars, but instead of breaking even we had lost $860,000. How was that even possible? Surely, there must have been some mistake. But there was no mistake. The normal financial presentation format, so useful for a traditional manufacturing business, was not so useful for an online business. In fact, it was worse than useless, it was downright harmful. Let's recast the Income Statement into a Cost Volume Profit format, not so good for our management incentive structure, but infinitely superior for business management purposes:

($000's) Revenue: Variable Costs Cogs: Discounts: Warehousing: Freight Out: Fixed Costs Employees: Consultants: Advertising: Overhead: Net Profit (Loss):

1089 548 751 152 134 141 111 44 41 (864)

Contribution Margin: -48%

Holy guacamole Batman, do you mean to tell me our Contribution Margin is really negative 48%? Yes Robin that's correct. Our discounts are meant to be one time only, but we can't limit them by customer so every order ends up sold 50% off. Said another way, for every additional $60 average order shipped our variable cost is $89 and we lose of $29. Said another way, the more we sell, the more we lose. Said another way, if we cut all our sales to zero and sat around and played ping pong all day we could continue to pay ourselves handsomely for two more years while at the current sales rate we'll be out of cash in three months. Said another way, now would be a very good time to pull the fire alarm. Jody called an offsite meeting for the management team to discuss our condition. The co-founder and four VP's flew in from their respective cities, and after Jody I was the number seven guy at the table. Also joining us were two more marketing managers, the customer service manager who was brother to Jody's wife, and the warehouse manager who had been there from day one. I had prepared the Income Statement in both the standard and CVP format showing our severe losses, a gross margin by line item report, and also a statement of Cash Flows showing us declaring bankruptcy in March. Not a single minute was spent discussing any of these statements. A classic business school question for any new business is: what is your competitive advantage? It's a good question. Ecomom sought to establish itself as a niche player catering to eco conscious moms. Not a bad idea at all. But once you get your brand you have to protect it, and here Ecomom was failing miserably. The Ecomom brand existed only at the website level and did not extend to the product level. Customers could easily buy the exact same item at Whole Foods or any of the other dozen or so internet retailers targeting the exact same market. And with comparison shopping as easy as clicking the mouse button, we became slaves to the lowest price. For diapers and baby food our contribution margin was close to negative 100%. For toys, our best product, contribution margin was almost zero, but here too we faced intense competition. Our own suppliers would list the exact same items on their own website. What value, then, was Ecomom providing to our customers? We became simply a middleman, and one that incurred double freight.

Perhaps, with enough market power, we might one day demand exclusive distribution rights for some products. Perhaps we might arrange for private label products sold at a premium under the Ecomom name. Perhaps our customer service and shipping department might one day become so good that customers would pay more for the convenience and satisfaction of doing business with us. Perhaps we might discontinue all low margin items and focus exclusively on items with margins of zero or better. Perhaps we might acquire a small manufacturer that could make use of our A+ customer service and distribution system. Perhaps with another $30 million or so we could hit our 2014 P&L forecast and reach the size necessary to make all these things happen. The management meeting, in retrospect, was surreal. None of these ideas were discussed in any serious way. No financial numbers were ever presented, except year over year sales growth, which of course looked fantastically good. Jody was upset and let everyone know it, but he never came right out and said "we are losing money." We discussed market strategies for selling the Ecomom lifestyle. We discussed the possibility of expanding our email and customer base and "driving more traffic into the funnel." We discussed moving the warehouse operations in house to Vegas. We discussed the advantages of expanding our Guatemala marketing team. It's been nearly half a year and I can't remember exactly what else was discussed, but I can tell you for sure the word "margin" and the word "profit" were never mentioned. Jody was a master marketer and led a management meeting that focused on an awesome feel good marketing plan. To pay for this Jody indicated he would bring in additional financing, possibly from People Fund, in the amount of $2 million. Surreptitiously, I called my recruiter and let him know I might be looking for another job soon. We closed November with $2.2 million in the bank and the real hope of "getting unfucked" as Jody would colorfully say, but before I tell you how our remaining cash reserves were pitched into the furnace, I want to play armchair psychoanalyst and tell you my experience with Jody himself. First of all, he was a great guy. Outgoing, personable, enthusiastic, funny, Jody never said no to a vacation request and bent over backwards to make sure every member of Ecomom got health insurance. I never heard him insult or say a bad word to or about anyone. Business wise he was full of ideas and excelled as a pitch man. On the other hand, he had some serious weaknesses too. He was not a numbers guy. I would bring the financial statements to Jody who would glance at them so cursorily and wave me away with "no one can understand this without extensive analysis." Critically, he did not understand margin. At the end of December when things were getting truly desperate, he said to me "Phil, just bring me a forecast that shows how much we need to sell to break even." He did not understand, after three years of negative margin, that increased sales resulted in increased losses. He had built his house by raising money and when times got tough he went with what he knew.

There were some big problems with the management structure too. First and foremost, the VP of Sales was compensated according to sales before discounts, not according to margin or profit. Our discount strategy resulted in enormous losses, but for the VP of sales the strategy optimized his bonus. Secondly, the business silo managers were separated by great distances. Each of them lived in a different city. Thirdly, Jody held financial information and control very close to the vest. I was the ostensible controller, and yet I did not have check signing authority or even access to the bank statements. I received only copies at the end of each month. Taken together, the compensation structure, the lack of financial information, and the lack of management cohesiveness allowed a poisonous discount strategy to grow for 8 months without anyone noticing. It took our $860k loss for Jody to notice, and by that time inventory had built up to $1.2 million to support that same strategy in the months going forward. There was no mechanism to identify this problem, and certainly none to talk about it. None of the VPs were privy to the financial statements and losses were not discussed in public. Our GM quit towards the beginning of December to pursue other opportunities ... did she know? She lived in San Francisco and I never actually spoke with her. I did shake her hand once a the Christmas party. Immediately following November's results Jody made some big changes - he dropped the discount strategy and the VP of sales left the company. It was a step in the right direction, but it was too little and too late. The company had never had a profitable month in its entire history so turning the ship around would not be easy. Laying off half the staff at the beginning of December and freezing sales might have given Jody another few months of breathing room, but the final bills for our huge inventory accumulation still needed to be paid and enough old discount coupons were still floating around that they would dog us for several more months. No substantive changes were made to the business strategy and starting from a $4.8 million capital raise in Aug for the 5 months through Dec 31st we lost $1.1 million after variable cost, spent $1.7 million more on overhead, and locked up another $1.2 million in inventory. We closed December with less than $1 million in the bank. Our bank credit line happened to be exactly $1 million was there a bank covenant? I did not know, and neither did our outside accountant who had worked for the company for three years. I dared not call the bank. I did not want to ask Jody. What kind of controller doesn't even know if his own company has a bank covenant? At this point I was debating with myself every day whether to fish or cut bait. In a long and complicated story that has nothing to do with Ecomom I was a dating a nice girl I had met out of town, and pursing the relationship would require me to leave Las Vegas. On the other hand, this was in many ways the best job I ever had and I was 30% Jody would raise additional funds and keep the business alive. At the end of the day I turned in my resignation on Jan 14, 2013; my last day of work would be Jan 31st. Over the course of January the consequences of the great failed gamble became apparent. Sales dropped off precipitously without discounts to only a few hundred thousand per month and we could not move a large portion of our inventory at all. We had built it, but nobody came. I had a front row seat to the painful disintegration of the company which,

as far as disintegrations go, was a relatively calm and orderly. I discontinued all payments except for payroll, benefits, and utilities. Even at this drastically reduced spending, and assuming the bank did not seize our assets, our forecast showed us out of cash by March. I never had a close relationship with Jody but I did sit right across from him in the office and overheard a large number of unsuccessful fund raising calls. I remember him quite clearly ending one with "well, I'm not really in love with this conversation either." For many calls he would end up leaving the office to speak in private. A week before the end, Jody asked me to draw up a forecast assuming half of the staff were let go and we used the empty space to transfer all our remaining inventory from Los Angeles. That was a painful assignment for me, and I didn't even have to face anyone. The last few staff meetings were very depressed, Jody looked haggard, and made a number of very morose comments such as "I feel terrible about this, if you guys want to fire me that's ok," and "I'm too old to start over." One week before the end he drew up his will and handed it to his secretary. On my very last weekend, January 26-27, 2013, I drew up multiple different forecasts at Jody's request. Some were 2013 P&L forecasts at different levels of revenue, and some were detailed expense forecasts with spending cut to an absolute minimum. I speculate Jody was either trying one final time to raise capital or preparing for severe downsizing otherwise. The failure of the business would be a bitter pill to swallow - it was Jody's baby for four years and he had hoped to reward all of his friends, angel investors, and employees handsomely. Instead he would be faced with humiliating explanations for lost money and painful layoffs of his loyal employees, many of whom had followed him from Los Angeles to Vegas. He was personally extremely pessimistic that he would ever be able to raise money again. Would he have to give up the big new house he had purchased not just a few months earlier? Would his gorgeous wife have to quit medical school and become a waitress to support him? I don't know anything about Jody's personal life, but I do know that Ecomom was his dream and his baby, and now his baby was dead. Jody committed suicide by shooting himself on Jan 28. On Feb 15, 2013, Ecomom entered into Assignment for Benefit of Creditors. Philip Prentiss 22 April 2013

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