Managing in Financial Adversity, Part 1 (#150)
/In this podcast episode, we discuss how to manage through a period of financial adversity. Key points made are noted below.
This is a request from a long-time listener, and it reads, “Can you do a podcast on what companies can plan to do in the event of financial adversity.” This is a good topic, but before I get started, it also might sound familiar, and that’s because I covered cost reduction analysis in Episode 103. That one was about which expenditures to cut back on if there’s a very specific need to cut costs. This is a bit different. The question is really a strategic one, and so it requires a different type of answer.
How to Handle Financial Adversity
So to begin, you’re experiencing financial adversity. What are you going to do about it? The answer comes from how a business gets into its current bind. Nearly all companies are in existence because somewhere along the line, they figured out a core business model that made money. And after that, they drifted away from the original business model. The drift usually comes from one of three things.
The first is that the original owner of the business wanted to keep growing, and he found that the original line of business wasn’t big enough. So he kept adding side businesses, which meant that instead of that one core, profitable business, he ended up with a cluster of somewhat related businesses, and he no longer knew where his profits were coming from.
The second kind of drift is when the original business model is failing, and the company is in the middle of shifting its resources somewhere else, where it hopes to find profits again. You might say that this isn’t drift at all, but a instead a very calculated move into a new competitive space.
And the third source of drift is when the owner sticks with the original business model, but then doesn’t pay attention to expenses. So perhaps he starts adding some corporate infrastructure, or maybe he spends money sponsoring his favorite racing team. Whatever the case may be, he’s adding expenses that aren’t really necessary.
And Bragg’s first law is that all expenses will continue until acted upon by an outside force. Which means that all of these incremental expense additions keeps piling up, and none of them ever goes away.
So we’ve reached adverse times, the company is losing money, and we’re in a hole that’s caused by one of these three problems. What do we do? Let’s deal with the last one first, where there’s a bloated cost structure. And then we’ll revisit the other two options in a later episode.
Dealing with a Bloated Cost Structure
You could call a meeting and try to do a general cutback in spending. That’s hard, because everyone’s gotten used to spending all of that extra money. But remember my first law. It’s really hard to cut back on expenses. So don’t do that yet. Instead, it’s time for some historical research. Go back in the financial statements as far as you can and create an income statement that shows all expenses as a percentage of sales. And then run that calculation forward, year by year, until you have a spreadsheet that shows the percentage of sales for each expense, all the way up to the present.
Then take a ruler and look across each row to see when each percentage increased. Because, trust me, they went up, not down. When you see an upward bump that stayed up, check to see what happened. Maybe you moved into a fancier building that cost more per square foot. Or maybe you hired someone into a particular position. Make note of all these items.
These were your decision points over the years that brought you to the current financial trouble. You might make a case that those were all good decisions. But. The reason I use your earliest years as a baseline is that the beginning of the company was when you had no money, and so back then you made decisions based on what was the least expensive. Well, if you’re now facing financial trouble, guess what. Your decisions should now be based on the same issues you dealt with back at the beginning.
So the decisions now become pretty clear. Which decisions do you roll back? It’s not necessarily all of them. But you can at least ask yourself, if you could roll back all of those expenditure decisions, what would company’s financials look like? If the result looks good, then you know you can dig yourself out of this hole. If the results still don’t look good, even with the reduced cost structure, then you need to think pretty hard about shutting down the business.
Another solution was made by the listener who suggested this episode, which is that he doesn’t allow payroll to exceed a certain percentage of sales. No matter what happens, he simply will not allow compensation expense to go past that number.
That’s not a bad approach at all, if you want to draw a line on an expense and fight to keep that expense from going beyond a certain point. At a minimum, it introduces a cost orientation into the business.
Converting Fixed Costs to Variable Costs
Now, what if the business is based primarily on fixed costs? And maybe it always has been on a fixed cost basis, where revenues have to be at a certain level, or else you cannot turn a profit. In this case, your historical information doesn’t give any clues about where to cut costs. As far as you can tell, there are no costs to cut.
If so, the trick is to convert the fixed costs to variable costs. And that means altering the nature of your cost structure. So if you have a large IT department, can you outsource it? Can manufacturing be outsourced? How about payroll? Or marketing? What about hiring a part-time CFO who’s paid by the hour? And so on. It can be difficult to get into this mindset, because it’s so different. What might help is to think in terms of outsourcing virtually everything. There’s nothing left, other than a coordination function. At that point, run the numbers and see if the financial adversity you’re in will still allow you to turn a profit. If not, there’s no way it will ever turn a profit, so shut down the business.
The Outsourcing Option
But if the model indicates that the company can make money, then work through the various outsourcing options and figure out which functions can be outsourced without damaging the competitiveness of the business too much. And then run the numbers again and see if you can stomach doing this.
Now outsourcing may very well be more expensive than keeping something in-house, but as long as you structure the outsourcing deals to have a variable cost structure that changes with usage levels, it allows revenues to go down without killing the business.
Parting Thoughts
So the main takeaways from this episode for dealing with financial adversity are to look at the historical decisions that brought you to where you are today, and switching from a fixed cost structure to a variable cost structure. We’ll keep going with this topic in the next episode.