Operating Techniques
Chapter 5 of Book:
The Laws
of Management Physics:
A Handbook for Hands-On Managers
A Management Book by Richard J.
Dadamo, Consultant
ISBN: 0-929392-35-3
© 1994, 2000
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Table of Contents | Preface |
Chapter 1 | Chapter 2 | Chapter 3 |
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When a company is struggling,
it’s
easy to make Ninety percent of the problems
can be
identified in a |
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Break-Even: The Foundation for Profit In a competitive market, you must remain aware of what sales level you need to survive. This minimum sales level is called the break-even point. To be more specific, the break-even point is the sales level needed to cover all categories of costs, but yield no profit. The Basics The various costs that must be covered by sales can be categorized as follows: Variable: Variable costs are those costs that are directly proportional to the sales level, such as materials, labor, and in some cases, allocated overhead. Fixed Costs: Fixed costs are those that remain the same regardless of the sales level. These costs would exist if the sales level were zero. Fixed costs include items such as rent and business insurance. Semi-Variable Costs: Semi-variable (or semi-fixed) costs are neither truly fixed or truly variable. For example, telephone service is a semi-variable cost. There is a fixed amount associated with the service and a variable amount that depends on the number of calls. Also, even though calls increase as sales increase, the relationship may not be linear (directly proportional). Semi-variable costs include costs that vary with volume, but not on a linear (or proportional) basis. For example, as sales increase, manufacturing indirect labor costs (such as supervision) also increase. However, this increase is a step function, which stays constant for a period and then rises, as opposed to being linear. For our purposes, we will consider semi-variable costs as fixed, but if a company were going to analyze the break-even point in more detail, the semi-variable costs would have to be broken out and analyzed separately. In reality, however, over shorter periods (such as a month), the semi-variable costs are basically fixed. Before you can determine the break-even point, you must determine both the variable costs (such as labor and materials) and the fixed costs (such as operating expenses). Once you have the variable costs as a percentage of sales, you can calculate the fixed costs as a percentage of sales (operating margin):
Finally, the break-even sales level can be calculated by dividing the operating costs by the operating margin (percentage).
For example, to support $70,000 operating expenses with a margin of 0.35, you must have $200,000 in sales. Two Examples To calculate the present break-even point, start with the latest summary of monthly costs. For our sample company, this data is given in Table 1. For a one-month calculation, it is important to examine the costs carefully to eliminate one-time glitches such as an annual insurance payment in the month being analyzed. Table 1 is the operating report for the month of August for our sample company. Note that while the company made money at the reported sales level, we are going to calculate the break-even point, the minimum sales level that would cover expenses. Practically, there are two important break-even points, one related to profit and one related to cash. The cash break-even point is lower than the profit break-even point because some operating expenses are not cash items. We will calculate the profit break-even point first, then the cash break-even point.
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Table 1: Break-Even -- Profit |
Table 2: Break-Even -- Cash |
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| A. Profit Break-Even Point We get the following information from Table 1:
Putting these numbers into our formula yields the following:
Thus $232,400 is the minimum sales level needed to cover fixed and variable operating expenses. So long as the company's sales reach $232,444, it will get by. Of course it is dangerous to operate at the break-even point because it doesn't allow for unexpected problems or provide capital for growth. B. Cash Break-Even Point Here we calculate the point where net cash equals zero. In Table 2, the data from Table 1 has been modified to eliminate the non-cash items, including bonus accrual, advertising accrual, bad debt reserve, depreciation, amortization, and part of the other employee costs. We get the following information from Table 2:
Putting the numbers into our formula yields the following:
Therefore, sales of $194,888 will cover all operating cash requirements and variable costs. Since cash is more significant when it comes to survival, sales only need to be $194,888 for the company to survive cash-wise. The Application If you want to reduce the break-even point in order to either lessen the pressure on the system or to increase profitability at the current sales level, you must analyze the data in Table 1 or 2 to determine which expenses could be reduced. Any reduction in expenses will lower the sales break-even point. If you want to calculate the break-even point at various sales levels for planning purposes, then you will have to analyze the semi-variable expenses for the different sales points, because it is unlikely that all costs can remain fixed. For instance, if sales increased, commissions would change, supply requirements would increase, telephone charges would go up, and indirect labor would eventually have to increase. The profit range above the break-even point
depends on the nature of the business. Low fixed costs and high variable
costs restrict profit more than high fixed costs and low variable costs.
This is illustrated in Graphs 1 and 2.
If we mark the curve at 10% above and below the break-even point, we can see that the difference (profit or loss) is greater when fixed costs are high and variable costs are low (Graph 1) than vice versa (Graph 2). Therefore, the cost structure from Graph 1 produces a greater profit per additional sale than that shown on Graph 2. On the other hand, when sales fall below the break-even point, the losses are similarly more severe.
Making a profit is important, and if you understand the break-even graphs for the nature of the business, you can manage your company more effectively. |
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There are some management terms, like ROI (return on investment) that many general managers (and presidents!) do not totally understand. However, they would never admit this to their peers or bosses for fear of sounding dumb or inadequate, so they go along pretending they understand when they really don't. Another such term is working capital and its derivatives, current ratio and liquidity. Everyone from banks to investors seems to be talking about working capital, because a healthy working capital can keep a company from going down the toilet. Unfortunately, if you don't understand what working capital is, it doesn't help you very much. Usually working capital is discussed in negative terms, such as "Your working capital isn't high enough," "Your working capital should be above $1,500,000," "The loan is in default because the working capital covenant has been violated," or "The company failed because they didn't have enough working capital." Don't these sound life-threatening? Companies do run successfully and overcome the handicap of not understanding these terms by using common sense. However, once these ideas are made clear, the businessman has a much better appreciation of the company's situation, and he can better manage the company's working capital needs. In effect, many companies are driven by working capital needs, even when they don't realize it, particularly if the company is managed from a cash perspective. Also, to successfully grow a business, you must maintain a healthy working capital. Definitions There are probably ten ratios associated with every line item on a balance sheet, but working capital is not a ratio, it is a real dollar figure. By definition, working capital is the current assets minus the current liabilities. It is a measure of how well the company is able to pay for the current liabilities using only the current assets. After covering current liabilities, mostly made up of what is owed the trade, any current assets left over are available to cover other operating expenses such as building maintenance, payroll, supplies, and capital equipment. If the working capital is marginal or low, then expenses other than those absolutely necessary must be delayed. These could include advertising and promotion, expanding sales overseas, new product development, regulatory qualification of products, and personnel expansion. A company with low working capital operates hand-to-mouth, hoping that the current assets, especially inventory and accounts receivable, can be turned into cash quickly to cover accounts payable and other expenses. Lots of working capital alone isn't necessarily good if the inventory portion is overloaded and converts to revenue slowly. If so, planned expenditures have to be depressed waiting for accounts receivable to be collected. Later you will see how to calculate the optimum working capital level for your sales level. The ratio associated with working capital is called the current ratio, defined as total current assets divided by total current liabilities. Often managers and banks feel comfortable with a current ratio of two to one or more. Since inventory cannot be transformed into cash immediately, there is a better measure of a company's liquidity, the quick ratio. This is defined as cash plus accounts receivable divided by current liabilities. Since many companies (particularly growth companies) operate with little cash, this ratio often boils down to accounts receivable divided by accounts payable. Managers and banks will usually feel comfortable with a quick ratio of 1:1. However, a one to one ratio may be marginal, especially if accounts receivable take longer to collect than your suppliers will wait to be paid. The resulting cash flow problems can limit your business's growth. Also, ratios near 1.0 or lower can be devastating to your business, as the liquid cash will hardly pay the trade, let alone the other operating expenses. In looking at a company's balance sheet, there are other factors that add into working capital, but inventory, accounts receivable, and accounts payable are the ones that dominate a growing company. The others have been left out for simplicity. For some companies, leaving debt and cash out of the working capital equations may be an oversimplification. Current liabilities do include near-term debt commitments, and a struggling company can have significant debt-service liabilities. Also, a company in good shape can have a significant amount of cash that should be added into the current assets. Keep in mind that inventory, accounts receivable, and accounts payable get muddied up by the accountants with reserves and accruals, and a manager can go crazy trying to understand the liquidity condition of a company after the accountants get through with the figures. A company that operates with little or no working capital can go on indefinitely, but it has no purpose, other than perhaps to meet payroll. All a company's dreams and potential dissipate if it can't build up enough working capital to grow. Also, one of the most common reasons businesses fail is that they run out of cash. Planning and keeping a close watch on working capital levels can prevent overspending or premature spending on material, supplies, or payroll, and leave cash for other working capital items such as funding increased accounts receivable and building inventory. Without the capital to cover these increases, the company cannot grow. Relating Working Capital to Sales Levels Example 1: In this example we are looking at a healthy manufacturing organization. Assume that the GM (Gross Margin) is 50%, or 0.5. The accounts receivable averages 60 days of sales, or 4 times the cost of goods sold (COGS). The inventory turns 4 times a year, or 3 times the COGS. Accounts payable totals 45 days of direct costs, or 1.5 times the monthly COGS. (There are certainly other things that are part of accounts payable, but the COGS is by far the majority.) Cash is equal to zero. By definition, the working capital (WC) equals current assets minus current liabilities. Therefore, we have the following calculation:
Sales is twice the COGS, so WC = 2.75 x the monthly sales dollars.
Example 2: In this example we are looking at a company with a lower sales margin. If the GM is 20%, or 0.2, then the sales are 1.25 times the COGS. Therefore the A/R average of 60 days would only equal 2.5 times the COGS. The A/P and inventory figures would not change. Note how the results change.
Sales is 1.25 times the COGS, so WC = 0.8 x the monthly sales dollars.
Although the current ratio is still high at 3.66, the working capital drops to less than 30% of its value in example 1, which says there is far less capital to work with than in example 1. This, in turn, means that there is less capital available to spend on needs other than trade payables. In order to grow, a company needs enough working capital to support the increase in inventory and accounts receivable. The calculations below show the difference in the major elements of inventory, accounts receivable, and accounts payable when the company's sales grow 100% in one year. The growth in accounts receivable and inventory can be treated as cash investments. Increases in accounts payable amount to a loan from suppliers, and they will offset some of the cash needs for increases in inventory and accounts receivable. Example 3: Assume that at the end of year one the sales are $1 million per month. Also assume that at the end of year two the sales are $2 million per month. The gross margin is 40%. The profit is $300,000 in year one and $900,000 in year two. The accounts receivable average 75 days, or 2.5 months of sales. Inventory turns are 3 per year, or 4 months of COGS. The accounts payable average 45 days of direct costs, or 1.5 months of COGS. Relating all the accounts to sales yields the following:
For sales of $1,000,000 per month,
For sales of $2,000,000 per month
Putting the major elements of working capital in the balance sheet at year end will show the following:
To fund the growth in accounts receivable and inventory would require an increase in working capital of $4,000,000. Some of this needed capital can be made up in profit ($900,000), but the net cash shortfall is $3,100,000. Therefore, in order to fund the growth, the company needs to obtain $3,100,000 from banks or investors. Even if the bank funded the accounts receivable growth at 80%, the company would still need $1,100,000. Otherwise, the company will not have the funds needed to build inventory or finance accounts receivable, and the company will not grow. An accounts receivable growth of $2,500,000 probably could not be funded by a bank line increase unless the bank loaned 92% against the receivables, which is very unlikely. As a result, new investors must be brought into the company, so you will have to sacrifice equity to fund the growth. Of course spectacular profit (like 22% after tax, which seldom happens) could in theory fund the growth, but even then, the timing of orders, shipments, and collections would have to be perfect. A company's management must focus on working capital both to make sure enough cash is available for growth and to make sure the company doesn't run out of cash. This important idea is one you need to understand clearly in order to manage your company well. "Budget
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Pricing
Your Company out of Business Continual pressure from competition will always push the price of a product down. However, lowering prices is one of the most dangerous possible strategies for dealing with these competitive pressures. While the market ultimately sets prices through competition, you must understand pricing structures to ensure that the sales levels, prices, and profit margins will cover all the supporting costs. Definitions and Terminology To begin with, we must understand the cost factors and elements that go into the pricing formulas.
Operating Expenses Sales Dollars Gross Margin, in this exercise, the will be defined as the percentage of sales dollars left over after taking care of direct costs. The gross margin must cover both operating expenses and profit. The gross margin percent would be calculated by dividing the gross margin dollars by the total sales dollars. The Break-Even Point is the price at which sales dollars cover all expenses but yield no profit. The Profit Margin is the percentage of sales yielded as profit. Determining Price -- The Basics The ideal pricing formula allows sales dollars to cover direct costs, operating expenses, and the profit target. Thus, the basic sales equation must be Sales Dollars = Direct Costs + Operating Expenses + Profit To make this equation useful for pricing, it must be restated as
When it comes time to set a price, you find yourself in a "chicken or egg" situation. You must decide which is to be determined first, the sales level or the operating expenses. Here, we will start by covering planned operating expenses, and for this example, assume that there are $60,000 dollars in operating expenses either planned or in place. If our goal is a 10% profit margin, the sales dollars must cover:
Direct costs can be developed as a percentage of sales dollars. In our example, manufacturing determines that the direct costs are $6,000 per unit, and marketing determines that the market price will be $10,000 per unit. Therefore, our direct costs are $6,000 out of $10,000, or 60% of the sales price. This leaves a 40% gross margin to cover operating expenses and profit. The company must now be able to sell enough units so that 40% of the total sales dollars covers both costs and profit. How many units are required? If our profit margin is to be 10% of sales dollars, we find that 30% of sales dollars are left to cover operating expenses. We know that the operating expenses of $60,000 must now constitute 30% of the sales dollars, so we can now calculate the total sales dollars required.
Simple calculation shows that the total sales dollars must therefore equal $200,000. Working backwards, we arrive at the following:
Since marketing has determined that the market price is $10,000 per unit, simple division shows that the company must sell a minimum of 20 units. When this is accomplished, sales dollars will cover direct costs, operating expenses, and profit -- and everybody will live happily every after! Determining Prices -- The Catch Covering the gross margin percentage is only part of the task. Unless you are bringing in sufficient real dollars, you are still not where you need to be. Continuing with our example, if sales is able to sell the product at a gross margin of 50% instead of 40%, but sells fewer units, the real dollars will still not add up. For 20 units, total sales would reach $140,000. At 50%, the gross margin actual dollars will equal $70,000, $60,000 of which must go to cover operating expenses. This leaves $10,000, or 7% of sales, to go to profit -- well below the profit bogey. However, there is an even more dangerous problem. Remember that competition forces prices down. In our example, let's say that sales wants a price cut of $2,500 per unit in order to be competitive. They claim that the market requires a price of $7,500. This would constitute a 25% price cut -- not that uncommon in some market segments today. This price drop would decrease the total sales dollars for 20 units to $150,000, yielding not a profit, but a loss of $30,000, as shown below. If the 10% profit is required, then the shortfall is even greater.
The profit target is important, but in tough times, survival is more important until adjustments can be made and a recovery is possible. During periods of intense competition, you must be aware of the break-even point, and maintain this last threshold until other adjustments can be made. Since the operating expenses must be covered in real sales dollars, the smaller the gross margin, the more sales will be required. For example, with a gross margin of 20%, sales would have to be $300,000, or doubled, in order to make it up. This shows the tremendous impact of a 25% price reduction. If we just want to break even, we must sell 40 units at the new price. If we want to hit the 10% profit bogey, we must sell 80 units at the new price. From a practical viewpoint, however, matters are much worse, because it is unlikely that the costs in place to support the manufacture of 20 units will be sufficient to support the manufacture of 40, much less 80! Therefore, operating expenses would increase, requiring even more units to be sold in order to cover it. This is the danger of selling a commodity product in a highly competitive market. It becomes necessary to seek out other, more stable markets, or find ways to add value and outstanding customer service in order to maintain a price advantage over the competition. An almost casual request from sales for a "competitive price change" has taken many a company with healthy sales and profit to disaster. Don't get on this toboggan!
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Almost every manufacturing company has an inventory problem to some degree. One of the most effective ways I had of entering a new situation was to start out by telling them, "You have an inventory problem." The analysis involved in their efforts to prove me wrong provided a quick way to get into the company's system and procedures. In fact, I have yet to find a manufacturing company that had perfect inventory levels and controls In every case, the first step to properly managing inventory is to truly appreciate the impact of inventory on profitability and capital availability and to treat the management and control of inventory as the important issue it is. Inventory and Profitability Controlling materials inventory is very difficult, so companies continually set aside reserves to cover unused inventory when it becomes surplus or obsolete. Excess inventory steals precious capital that can be used in other aspects of the business such as new product development. It puts an unnecessary burden on cash resources that could be used more effectively. I have encountered numerous situations where management was feverishly looking for outside capital that they easily could have found internally by making better use of assets that were already available such as inventory and accounts receivable. It's almost a year-end ritual for the president of a company to pace like an expectant father while the books are being closed, waiting for the actual inventory numbers to come out. Then he breathes a sigh of relief when the actual inventory is only 2-3% off the book value and proceeds to make the necessary adjustments. But is that sigh of relief justified? The physical inventory may now have a new book value, but that doesn't say much about the inventory's "true" value. More likely than not, a significant amount of inventory is no longer useful and distorts the book value. Inventory has a tremendous effect on profit; therefore it can be used to control profit. In fact, the physical inventory itself yields little information about inventory's impact on profit. To assess the impact on profit, you must relate the discrepancy between physical and book inventory values to the Cost Of Goods Sold (COGS). For instance, at year end, a company decides that inventory is overstated. Analysis of the problem indicates that the error has accumulated over the year, and therefore the COGS used in the profit statement each month has been wrong. Even if the inventory is only one or two percent off, the profit figures have been wrong all along. For example, let's assume that a company has sales of $10 million with a COGS of 50%. After expenses, the pre-tax profit is $480,000, or 4.8% of sales. The inventory value is about four months of COGS, or $1,700,000. At this company's year-end, the physical inventory is $120,000 less than the book value and is not covered by reserves, so it has to be written off. This means that the profit of $480,000 was overstated by $120,000, leaving an actual profit of $360,000, or 3.6% of sales. This is 25% off the original profit figures. For a company selling at 20 X after tax earnings (assuming a 40% tax rate), this means a valuation change from 5.76 million to 4.32 million -- quite a distortion! In addition, the above calculations assume that inventory has been counted with no regard for "real" value; therefore, the write-off might be even higher. However, people have a natural tendency to hold on to inventory even when it is no longer useful, delaying the impact on profit. Many people have a "string saving" mentality and hate to throw anything away, reasoning that it might be useful someday. On the other hand, I've seen components counted as useful inventory when they have been sitting in plastic bags so long that the bags have changed several shades of yellow. Obviously, the longer something is in inventory, the less likely it is to ever get used. Often, we find a tug of war between the finance people, who want to reserve for all potential write-off, and the president, who is reluctant to make reserves too high because it hurts the bottom line. Organizational Response to Inventory Problems Whenever upper management takes steps to resolve an inventory problem, there will almost inevitably be resistance from the organization. Seldom will a manufacturing manager admit to an inventory problem. Generally, there is a natural process of denial and resolution an organization goes through before these changes can be implemented. Phase 1: "Bean counters can't count!" Usually the top management first identifies an inventory problem and the operating organization is the last to acknowledge it. After all, if they knew there was an inventory problem, they'd be solving it. When confronted with the problem, the operating organization is bound to react with surprised disbelief to accounting's numbers. Phase 2: "I'll prove that you're wrong!" Most likely, manufacturing will take its own inventory count, which will, of course, have numerous discrepancies. Then there will be a long period devoted to proving that no problem exists instead of trying to understand the problem and begin to solve it. Phase 3: "The Hero" After either acknowledging the problem or accepting the mandate to reduce inventory, the commitments finally start. As a rule these initial commitments for improvements are far overstated and include dramatic promises for quick solutions. One solution that is usually proposed is to sell back the material, but this either never materializes or fails to get the anticipated prices. Then usually within the first month or two, the bubble bursts. In many cases, the inventory even goes up during this period. Phase 4: "The Let-Down" Finally, reality sets in and everyone finally gets the message. Existing controls and systems are strengthened, and new ones are established. People are assigned specific tasks and responsibilities, goals are set, and slowly but surely, things start to happen. Inventories have inertia, because they are seldom, if ever, balanced. For this reason, even with too much inventory, a company often needs to buy material to balance the build plan and resolve the inventory problems. ***** Throughout this process the most essential and most difficult task is getting this one message across: You must understand and control how outside purchases, inventory, and the COGS (both required and projected) interrelate. Keep in mind that inventory cannot be reduced unless the "goesinnas" are less than the "goesouttas." In any recovery plan, management should be monitoring and graphing material receipts, new purchase order commitments aged by month, and the projected COGS, all on a monthly basis. If more material is coming in than is needed to service purchase order commitments, then stop the process and resolve the problem. Inventory Turns A classic method for calculating inventory turns is to determine the number of months in inventory by dividing the total inventory dollars by the average COGS for the last several months. The result is the number of months in inventory. Dividing this figure into 12 (months per year) gives the number of inventory turns per year. For example, if you have $1,000,000 in inventory and the average monthly COGS over the last quarter was $290,000, you'd have 3.5 months of inventory, or 3.4 inventory turns. But, before you beat up anyone to increase turns to 6 per year, take the time to understand how accounting treats inventory. Every company has a different optimum number of turns. Therefore, for each company, you need to look at the unique needs of product support, competitive deliveries, financial requirements, the cost of money, and inventory needed for marketing (marketing samples). If accounting treats all the various elements as inventory, then the total can easily be twice that needed for manufacturing alone -- yet most inventory turns evaluations are driven to manufacturing. The following list shows various elements of inventory that work against higher turns per year:
As should be obvious from this list, what you see is not necessarily what you get. Naive assessment of inventory turns by an executive or director will only alienate management. A Few Observations Inventories are seldom in balance for any number of reasons: Purchasing overbuys, product mix changes, customer schedules change, and various materials have different lead times. I once inherited an organization where, at the rate we were shipping, we had 20 years worth of Sears green paint in inventory! Creative accounting can include such things as materials handling charges, absorbed and unabsorbed overhead and labor, and the timing of material variances. These play havoc with the bottom line, making it appear better or worse than it actually is and leading to decisions based on inaccurate information. Purchasing personnel naturally want to look good, and therefore tend to overbuy in order to get the lowest price and to approve deliveries as soon as possible so they aren't caught short and beaten up for late deliveries. Both practices increase inventory needlessly and hurt cash flow. Many engineering organizations insensitive to inventory will make product changes effective immediately. Often it would be better if they delayed product changes for a while, using up inventory that would otherwise have to be abandoned as obsolete and reducing the cost of the product change. The implementation date can be used to help the company's bottom line if engineering takes the time to explore inventory and manufacturing needs. Most companies start out with a policy that only allows material to be purchased if existing customer orders cover it. This is great control, but as sales grow and the market broadens, competitive pressures such a price and delivery force the company to begin ordering larger quantities of materials and to order them in advance. This can be traumatic for small companies with little or no sales forecasting and forces management to change planning strategies. When a company has large customers, good managers will make sure marketing and/or sales stays on top of the customer's inventory situation. This helps prevent nasty surprises, like a customer stopping delivery for a while. Ironically, in turn-around situations banks become hostile about inventory reductions. Even though the improvement increases the chances that the loan will be repaid, it also decreases the collateral on the loan. Large and aged inventories are susceptible to loss through theft, spoilage, and product changes or redesigns that render components obsolete. Large inventories can create manufacturing inefficiencies. Production lines are more likely to become unbalanced with excess materials and personnel, testing and debugging have less urgency as "cherry picking" becomes the norm, and more space is required to store the materials that would otherwise not be necessary. Everyone
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Return on
Investment (ROI) ... Return on investment (ROI) is most easily understood using a common-sense approach. To evaluate an investment, compare the potential return against that of other common, more secure investments. Ask the question, "If I invested this money in a bank account, CD, mutual fund, or treasury note, how much would I have after the same length of time?" ROI can be calculated and discussed in a number of different ways. Most simply, the ROI is the difference between what you get back from the investment and what you put in: Cash Out - Cash In = ROI Many people like to think of ROI as a percentage of the original investment:
An investor in a company can also see a return if the company increases in value. Valuations can increase even without profits, as happens frequently in the high-tech market. Such a company must be positioned in a hot market and promoted properly to be perceived as having significant potential for future sales and profits. When this occurs, value can climb hundreds of times the original investment even before the company is profitable, and ROIs can be fantastic. However, this type of investment is highly speculative, and the huge returns are the exception, not the rule. As we get into accounting jargon, there are also variations on ROI. For example, in one large, multi-billion dollar company I was part of, they used the term ROAE (Return on Assets Employed). Unfortunately, I'm certain that half the division managers in our group, most with sales over $50 million, didn't know what the term meant. In effect, the company had made available for the general managers' use millions of dollars in shareholder assets. Since the risk was much higher, they were expecting a better return on the use of those assets than they could have gotten through bank accounts or other, more secure investments. In this company, however, I always found that the corporate emphasis on ROI and cash flow seldom carried through to the smaller corporate entities. Time and time again I attended off-site meetings with scores of general managers in the audience, and invariably, during presentations on ROI or cash flow, they were figuring out where to go to lunch or thinking about that evenings' poker game. And it isn't only big companies that need to understand ROI. Even small companies owned by the president don't think about ROI as much as they should. So long as the owner is taking money home, or the company's value is rising, ROI doesn't get highlighted. On the other hand, it's a given that with a good, consistent ROI, a company's value will continue to rise. The owners never stop to wonder, "What would happen if . . ." or "What couldn't happened if . . ." I have found that the following is typical of a growing, high-tech company with sales of $10 million:
Therefore, excluding inventory and accounts receivable, which are also assets that can be used for growth, the cash available for investment in futures is $3 million. This includes profit, budgeted amounts, and the bank line. Before deciding to invest this $3 million in a new product or service rather than in a more secure type of investment, management must consider whether the sales derived from the new investment will be enough to provide the expected return. This is a lot of money to put into a high-risk investment! To evaluate the investment we need to determine what sales level will provide the expected return. Assume that future sales will yield the same 5% profit over three years. Because the company is determining the return rather than an outside investor, we can assume a modest return of 15% on the investment. A 15% return on $3 million over 3 years is about $1.5 million. Added to the initial investment, the total return expected after 3 years would be $4.5 million. (This does not take into account changes in the value of money and cash discounts.) Planning on a 5% profit level is the same as saying that sales will be 20 times the expected cash out. Using this simple calculation, the investment would have to produce sales of $90 million over those three years. Unfortunately, very few $10 million companies come anywhere near that kind of growth in three years from a new product, so most of these investments get a far smaller return. To see how changes in ROI and profit affect the calculations, and to examine those calculations in more detail, look at the following example.
therefore
Therefore, over 3 years, the dollars out of the investment should equal the original amount ($100,000) plus 15% of the $100,000 each year for 3 years ($45,000). We can write this as
Since, at 5% profit, sales must reach 20 times the expected profit amount, over 3 years the sales level required can be calculated as follows.
Thus, to yield a 15% yearly gain on an investment of $100,000, the sales produced by that investment over 3 years would have to reach $2.9 million. For comparison, if the same amount of money were put into a security that yielded 8% (compounded over 3 years), the gain would be $25,971, or $19,029 less than the investment above. If the profit level were to be 10% instead of 5%, then a sales level of only $1,450,000 would be needed.
If an ROI of 25% were required, sales would need to reach $3,500,000.
A number of additional considerations can be included in a more thorough analysis, but are not needed for a quick comparison to the other types of investments. Some of these considerations include additional risk in inventories and receivables, a future decrease in the value of cash, and a quicker return on the higher contribution from sales as the product is added on an incremental basis to the existing business. The impact of some of these factors can be accounted for by adjusting the ROI level required. Many have attempted to relate the risk to expected success factors and, therefore, to the level of return required. Especially when several investment opportunities are vying for a limited amount of investment capital, people try to develop all kinds of internal models and formulas to help in the decision-making process. The key is to compare the potential risks and returns of investment in a new company or product against the alternatives. With a low risk and highly secured investment, you know you'll eventually walk away with your original investment plus a gain. So, investments in company start-ups and new products and services need to be compared carefully to these more secure investments to determine if the rewards are worth the risks. The first
questions a president / owner must |
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The
Goesinnas Must Exceed The successful small company executive will find growing a company an experience very different from the total control he may be accustomed to. He will soon learn that rapid growth is synonymous with compromise. In a rapid growth situation there may not be time for him to think through every action or decision. Rapid growth often requires a manager to make decisions in a limited time and to solve problems with the less-than-ideal resources and information he has available. However, even in growth, the successful small company executive must maintain the good habits he had developed and avoid the pitfalls of the "budget manager mentality" so prevalent in large corporations. Above all, he must never forget: The goesinnas must exceed the goesouttas. In my experience working with smaller privately-held companies, I have seen that the small company executive must have and use many strategies and skills that would help in managing for profit in larger corporations. The small company executive must be a good businessman in order to survive. Thus, the $64,000 question is, "What is a good businessman?" To begin with, a good businessman understands survival, and recognizes that if the cash coming in is less than the cash disbursed, he won't survive for long. He is, in effect, a cash manger, and understands that "the goesinnas must exceed the goesouttas." As a result, he makes wise decisions about what he can afford to spend in marketing, engineering, and operations, often without detailed analysis and without fanfare. He simply makes good ROI decisions, and he may do this instinctively, even when he couldn't even define the term "ROI." The good businessman can do all this because he truly understands what he can afford. He doesn't have extra employees because he wouldn't make payroll. He won't buy and build inventory unless he knows he can sell it -- and pay for it. He can recite chapter and verse on what it costs just to open the doors each morning. He does not get confused by accountants with their accruals and reserves. He thinks cash; he knows what it can buy and how much he'll need to cover his expenses. He doesn't allow himself to be taken by surprise or to turn a good profit year sour with adjustments to standard costs, reversal of reserves, or devastating accounts receivable or inventory write-offs. He refuses to be misled by adjustments to reserves, accruals, or standards that create moving hurdles he must overcome in order to understand his business. He knows that just as profit is the muscle of his company, cash is the blood. He knows what cash comes in from sales and what goes out in operating costs. In essence, the good businessman manages for result (profit), whereas a budget manager manages for a number (budget). Why then can't the profit line managers in bigger corporations apply this principle in their decision-making? One would think that at the top levels they have the same objective -- to make money. So how does the large company executive manage like a good businessman? First, he would have to take the emphasis off paper profit and loss and put it on cash. He also must resist the pressure to increase sales at any cost -- especially when the cash is not available. Instead of functioning as a budget manager, he must function as a cash manager. I have seen managers meet million-dollar operating expense budgets within a fraction of a percent and yet miss the bookings goal by 20% . . . resulting in outrageous losses. Unfortunately, the larger the operation, the more forgiving upper management can be and the more priorities can get confused. I have sat in planning meetings as part of a group doing $500 million a year in sales. If a division manager said he was going to miss his plan for the year, the first thing the group leader would do is to ask his financial manager if there were sufficient reserves to cover the miss, taking the operating manager off the hook. In this same group, the business planning cycle, which began in late September because of the size and large number of divisions, demonstrated the same mixed-up priorities. For example, because the company had a centralized marketing organization, the planning cycle began with their sales forecast for the following year. Then, all of the operating divisions based their budgets on these numbers. After several weeks of intensive give and take, the division managers would reach a difficult and unpopular budget compromise that met profit objectives. No sooner was this completed, however, when marketing came back with a reduced forecast, still long before the year had begun. And how was this resolved? Instead of directing marketing to go back and figure out how to meet their original forecast, the managing executive directed all the operating divisions to cut back some arbitrary percentage of their hard-fought budget in order to fit a new group profit goal. Marketing was now off the hook, leaving everyone else scrambling to clean up after their mess. Experiences like this began to generate a belief that, "We will meet the expense budget regardless of sales." Eventually, this developed into, "Spend it or lose it." Sadly, I heard one peer say, "Gee, I'm below my travel budget for the month, so I think I'll make a trip." No one showed any regard for cash flow. Instead, the mind set was, "We'll need $8 million this year, but it will magically appear from corporate never-never land." As this company began the year, the divisions went to work, and the first monthly statement looked great. When I looked more carefully at the profit and loss statement, however, I found significant adjustments for material variances, labor variances, bogus inventory reserves, questionable bad debt reserves, and numerous accruals. So how was business really doing? The next month everything could have been reversed by overzealous accountants. Worse yet, management had to sit and wait until the end of the year like an expectant father waiting to see the final product while accountants toss their "baby" around like a yo-yo. And even then they couldn't relax, because all that accounting mumbo-jumbo had to then be scrutinized by corporate finance and blessed by an outside accounting firm. In addition, under these circumstances how is a manager to know in a timely manner how his business is going from day to day? At times, not knowing this information can be a serious liability, masking the severity of a damaging situation. Even worse is the self-deception of significant inventory write-offs. Often interpreted as "just another December adjustment" or "one of the pitfalls of doing business," it is actually an overstatement of profit for each and every month. Meanwhile, in those overstated months, there has not been the much-needed pressure to reexamine the entire system from head count to pricing. In reality, any adjustment in inventory indicates that the cost of goods sold (COGS) was not accurately stated in the monthly figures. The problem is further magnified with a larger total inventory. TO ACCURATELY SPOTLIGHT INVENTORY ADJUSTMENTS THEY MUST BE MEASURED AGAINST THE CURRENT COST OF GOODS SOLD, NOT AGAINST THE TOTAL INVENTORY. Inventory is just one example of how an apparently successful manager in fact may not be doing what really needs to be done, aided and abetted by a corporate culture that will leave the operating entity alone so long as they are "on the profit curve" for the year. No one is anticipating this type of problem, so it takes everyone by surprise after it is too late to do anything about it. Evaluating performance must involve much more than a near-term profit figure, particularly in a large company where independent departments operate with individual goals. Meeting an inappropriate goal doesn't contribute to the company's success, so the goals must be coordinated, and everyone must be focused on the success of the entire business. For example, a friend of mine was a vice president of operations in charge of manufacturing for a $250 million dollar computer company. He was justifiably proud of the fact that he was meeting all his goals for the year. He was meeting all production schedules, improving productivity, and meeting his cost reduction targets. Unfortunately, company sales were well below the planned levels, and he was filling warehouses. Goals were not well coordinated, and the company's right hand truly did not know what their left hand was doing. Given all these problems, how should the big-company profit manager operate? First, he must get an accurate overview of the entire business and understand on an ongoing basis what it should cost and what level of sales will be required to operate profitably. This understanding should not have to wait for precise accounting numbers, however, because accountants' manipulation can mask problems. He can break current expense figures down to whatever level he is comfortable with, but he should be able to identify fixed, variable, direct, and indirect costs. The direct cost of sales, specifically labor and material costs, needs the most watching. All the other costs, including rent, indirect labor, insurance, depreciation, travel, and advertising are fixed (or nearly fixed) on a short-term basis, and so can be determined by averaging recent expense figures with sufficient accuracy. This done, it is imperative for the profit manager to track the major variables affecting profitability. Cost levels, particularly labor and materials, must be consistent with available sales dollars. Therefore, the profit manager must know the following:
Although these three points seem obvious, large company managements often wait too long to take the necessary steps. Because cash is almost always available, the manager doesn't have to worry about paying suppliers or meeting payroll. In small companies, cash availability can be a significant management control. There are few things more sobering than trying to meet a payroll when cash is tight. Starting with labor, the large-business profit manager must then determine what amount of labor is needed to support each level of sales. He can then convert current staffing levels into required sales level. For example, a company that averages $60,000 in sales per employee per year must have $6 million per year, or $500,000 per month, in sales to justify 100 employees. When the backlog isn't at $500,000 per month, the manager must carefully evaluate the level and timing of new orders. Note here that it is important to analyze the aged backlog and not the monthly average. A $2,500,000 backlog may not cover five months of costs if the shipment schedule is spread over twelve months. In this case, any given month may have committed sales of half or less of the required $500,000. Going beyond backlog, forecasts can also be converted quickly to staffing levels, and if the forecast and backlog cannot support the current payroll, the profit manager must seriously consider reducing the number of employees. It doesn't require accounting department accuracy to spot inequities in labor and materials. One of the most significant indicators is the "book to bill ratio." It is a law of management physics: EVENTUALLY A COMPANY'S SALES LEVEL WILL REACH ITS BOOKINGS LEVEL. Even if staffing and sales are currently well balanced, a book to bill ratio below 1.0 may require the profit manager to reduce the number of employees. Failing to respond promptly to such changes in the sales level sets the company on a spiral to oblivion, and history shows it has cost many managers their jobs. While there is no doubt that the quickest and most effective way to reduce costs is to reduce staffing levels, in many manufacturing companies subcontracting and the use of overseas resources are rendering labor a smaller and smaller percentage of the total cost of sales. It is not unusual, particularly in the systems business, for materials costs to be more than 50% of the total cost of sales. In addition, material costs are like a time bomb and can be far more devastating if mismanaged. As a result, good control of materials and materials costs must be the focus of significant management attention. In some businesses labor is essentially a fixed cost over a range of sales levels, making materials the only significant ongoing variable cost. Just as in evaluating labor needs, materials needs can be related to the total cost of sales, and more importantly, to the pricing. After establishing the sales to materials relationship, the large business profit manager should track materials in three important areas:
Note that the third point must drive the first two. If purchasing is buying at a rate above the COGS level, inventory will build and cash needs may exceed future collections, creating a negative cash flow and the high risk inherent in having too much inventory. Therefore, it is important to monitor purchasing and purchase orders. Scheduled delivery dates are very significant, and the delivery schedule should be coordinated with the COGS timing needs in the manufacturing schedule and sales forecasts. It is also wise to track the material received and compare it to the cost of the goods going out the door. Receipts should not exceed the materials needed for scheduled shipments. Purchasing personnel often contribute to the problem. They tend to over order to obtain volume prices, and they try to accelerate deliveries in order to avoid being responsible for late deliveries. It is also not a bad idea to check receiving periodically to ensure that suppliers are shipping the correct amounts and to keep from receiving materials ahead of schedule. This check can save the company excess or ahead-of-schedule payments. Comparing receipts to shipping rates can also be an effective measure of purchasing effectiveness. They may not be overbuying, but they may be receiving too soon. Material relieved long before it is needed for manufacturing puts a strain on cash flow, as it means paying vendors long before the material can be used in shipments and collected on. Excess labor can also build product inventory, and it can create manufacturing inefficiencies not covered by pricing. Excess product inventory this month means that less needs to be built next month. This, in turn, means that even less labor is needed next month, and if the labor level is not changed, it will raise the product inventory even further. In trying to prevent labor inefficiencies, more material is fed into the system and the situation begins to spiral. Inefficiencies and excessive inventory almost always result in a write-off. In addition, it allows profit managers to develop a false sense of security. From an accounting viewpoint, high product inventory makes the current month's P&L look great, as excess labor and overhead are absorbed into inventory, distorting cost and profit figures. Building product inventory is putting a problem on the shelf that will come back to bite the manager later on, when he has to take large "surprise" write-offs. Controlling payroll to prevent excess labor can help prevent this problem, but most budget managers will resist making the needed changes, hoping that somehow the shortfalls will be overcome. One division manager I worked with believed that he could maintain $50,000 revenue per day, yielding a million in sales for the month (20 working days). The first week yielded only $20,000 per day, or $100,000. This meant that he would have to average $60,000 per day for the next three weeks. The second week only yielded $150,000 ($30,000 per day), but he still believed he could attain his goal. However, his goal now required that he average $75,000 per day for the remaining two weeks. Even so, he stuck with his plan, kept the staffing levels high, and failed. To make matters worse, the missed shipping level resulted in excess material and overtime hours being used to try to meet the original commitments. A good manager doesn't need to wait for accounting to tell him how his business is doing. He watches the gross margin by keeping track of the backlog, shipments, new orders, and forecasted business. If the margin is decreasing, he needs to reduce the expense base. Pricing should reflect direct labor and material costs, and reports should include the margin and product mix, as these heavily affect performance. In reality, the large business general or profit manager should not commit more than he can afford to pay from expected sales proceeds, even if cash is available from some higher level. Managing from a cash viewpoint will often prevent problems later on and increase the likelihood of profitability. Even a budget manager can be more successful by managing from a cash viewpoint once he understands that you should not spend money unless the income side will allow you to pay as you go. In the final analysis, the responsible manager recognizes that the goesinnas must exceed the goesouttas! |
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Product
Mix, Product
Margin
Do not assume that managers responsible for profit
understand profit -- or the things that make a company profitable. It is
not unusual for managers not to understand return on investment (ROI) or
return on assets employed (ROAE). I remember sitting in a meeting with
40 division managers, and I am sure that at least 20 of them didn't
understand the presentation on ROI. None of them, however, was about to
display their ignorance in front of their peers by asking the obvious
questions. After all, everybody assumes that general managers just know
these things. Unfortunately, most companies take few if any
steps to ensure that their managers understand such concepts. Very few
companies provide formal training for general managers, assuming that
they either retained this from their college education or learned it on
their way up the corporate ladder. The problem is aggravated in high
growth situations, where people are often promoted even before they've
had a chance to learn their current job. Ironically, it is generally a
very short time before they're treated like they've been there forever
and know everything. At the other end of the spectrum is the slower
paced environment where the knowledgeable and competent employee who's
been around forever is passed over for a promotion in favor of the
outside hire. Usually this happens only because the current employee's
faults are known, but the outside hire is only displaying their best
side. The saying is true: Familiarity breeds contempt. However, it is
often overlooked that the outside hire will not bring to the job
instantaneous understanding of the corporate culture and the subtleties
of the product and product mix like the current employee would have. All the training in the world, however, will not
necessarily make a manager sensitive to the impact of product mix on
profitability. One of the most subtle aspects of managing a profit
responsibility is understanding and optimizing the product mix. For years it has amazed me how many pricing
formulas are put together that supposedly guarantee a 20% pretax profit
-- and later yield only 2% or even a loss. Forcing that manager to find
the lost 18% usually results in a very educational experience for him.
Of course, the danger is that most pricing formulas are put together
without allowing for such "little glitches" as bad debt,
inventory obsolescence, or, most importantly, changes in the product
mix. In larger companies managers tend to base pricing formulas,
projected manufacturing overhead, and general and administrative
(G&A) rates on a theory or single approach, regardless of the nature
and idiosyncrasies of the product and the mix. Many business plans are
also put together without a detailed breakdown of the product mix. In
fact, even when the mix is forecasted, it rarely comes out as
forecasted. Product costs are fairly simple to understand and
budget for when a company builds only one product or manufacturing
sticks to a build plan for the whole year. Unfortunately, the mix of
products sold and the sales level (even of only one item) tend to change
as the year goes on. Early in the year the management plan was neat and
tidy -- but it assumed that the product mix and the volume sold would
follow the forecast. After subtracting the direct costs, they divided
the remainder up neatly on a percentage basis to provide for supporting
costs and quality. These costs per unit were then added to the direct
costs to be used in the pricing formula. Now this all works out fine if the output is
constant and predictable. For example, company X expects to do $10
million in sales, with 50% of the price going to direct costs, 40% to
supporting costs, and 10% to profit. To determine the appropriate price,
all they have to do is identify their direct costs and add the
appropriate percentages for supporting costs and profit. If they sell
$10 million, $5 million pays direct costs, $4 million pays supporting
costs, and they make $1 million in profit. Very neat and tidy, but most
companies are lucky to have a month clearly defined, let alone a year! More likely, one day company X will find that
they're only going to sell $9 million. Once they subtract out half ($4.5
million) for direct costs and the $4 million they will still have to
spend in supporting costs, they will find only $500,000 left for profit.
(See Table 1.) Table 1:
Even when standard costs for products are determined, the resulting calculations can still be misleading. The primary reason for establishing standard costs is to provide management with a handle on how the business is going from day to day without making them wait for delayed accounting reports. Companies have their own techniques for evaluating standard costs, all of which have their flaws. I worked in one company where standard costs were based on the theoretical capacity of the plant in terms of labor and the estimated average material costs for the year. This approach guaranteed that the standards would be adjusted for accuracy throughout the year, but the reality of the situation was that we spent many long hours in meetings trying to analyze the variances and their impact on profitability and pricing. (See Table 2.) Table 2:
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Of course the ideal situation is to have low fixed
costs and low variable costs, as illustrated in Graph 3. Sales
increases still yield greater profit increases, but the effect (and
likelihood!) of losses has been reduced considerably. Therefore, once
the break-even point is reached, if fixed costs can be held in check,
sales increases will yield significant profits.