Managing in Financial Adversity, Part 3 (#153)
/In this podcast episode, we discuss how to manage through a drop in profits when a company has many products and subsidiaries. Key points made are noted below.
I had talked about three ways in which a company can get into financial trouble. Episode 150 covered how to retrench when you haven’t been paying attention to controlling expenses. Episode 151 covered how to manage a situation where you’re trying to shift from one failing business model to an entirely new model.
Managing Through a Complex Scenario
And that leaves us with one more scenario, which is what to do if the company is in financial difficulties right now, and the business has lots of products, or product lines, or subsidiaries. Basically a tangled mess. The goal is to sort through the mess and figure out what can be pared back right now in order to keep the company out of bankruptcy.
This is a case where you really can save a business with cost accounting, because the main point is to use direct costing to figure out the incremental cost of – well – just about everything. Direct costing is when you only assign variable costs to cost objects. A cost object is anything for which you want to separately measure the cost. Since I don’t want to sound too theoretical here, let’s do some examples.
The first example. A business has fallen on hard times, and it produces an enormous number of products. Management might ask, how about if we save money by cutting back on some of these products? Each of the products is a cost object. What we want to learn about is what specific costs will go away if we cancel some products. We use direct costing and figure out that nothing but the direct material costs will go away if we cancel products. So, unless the products are selling at below the cost of their direct materials, which is not likely, then it doesn’t make much sense to cancel any of them. I talked about this back in Episode 92.
This doesn’t mean that you can’t cut costs in the area of products. But rather than cancelling products, use direct costing to figure out the margin you’re actually earning on each unit sold of each product, and then emphasize selling the ones with the highest margins. The low margin stuff only gets produced last, if there’s some remaining production capacity available for it.
Here’s another one. Move the whole concept up a notch, to a product line. They’re all produced out of a single manufacturing facility, where the same set of production equipment makes a dozen different models. In this case, the logical cost object is the entire facility and everything produced in it. So, you’d use direct costing to figure out the incremental cost of this entire bundle, which means the product costs, the facility, and any associated materials management staff, and salespeople, and management, and so forth. If the entire bundle loses money, kill it.
Cost Object Analysis
Now let’s talk about some other cost objects besides products. What if you’re running a retail chain? The cost object appears to be at the store level, so you use direct costing to figure out if there’s actually a savings associated with shutting down a store. There may not be, and in fact, every time you shut down a store, the overhead cost of the distribution warehouse for that region is now spread over fewer stores. So the real cost object may be an entire cluster of stores, including the warehouse. And, for that matter, the regional store manager and any related administrative staff. This means you analyze the situation based on which costs go away if the entire region is shut down.
Let’s shift to sales channels. I’m talking about selling through distributors, versus retail stores, or a web site, and so on. Each one can be considered a cost object. So. Accumulate incremental costs for each sales channel, and see what you find. For example, you might find that the company is spending a mint developing a web store, and isn’t making much money from it. If so, an option is to cancel the website, and the marketing budget for it, and the programmers, and so forth.
And one more cost object. What about customers? This can be a tough one to analyze, because the staff always bitches about certain customers who seem to chew up an inordinate amount of staff time. They’re probably right. But the question is, if you refuse to do business with a customer, what costs really go away? Will you really eliminate staff positions? Unless it’s a really large customer, the answer is – probably not.
Now all of this discussion of cost objects comes down to, which ones do you chop, and which ones do you keep? There’s really no waffling around on this. It’s a binary solution. You save the most money if you completely eliminate a cost object. If you try to keep it, but at a lower expenditure level in order to keep your options open, then you don’t save as much money. In short, you need to be decisive about completely cutting out entire cost objects and all of the costs associated with them.
Now this may sound like I’m advocating attacking the business with a battle axe. That’s basically correct. But. If you do it properly, chunks of the business are taken away that were holding back the rest of the company. That means a proper expense reduction might not even touch the most profitable parts of the business. In fact, you could reallocate funds from the areas being eliminated and use them to increase spending in the most profitable areas.
The sad part about all of this is that a business with a cluttered mess of products, and subsidiaries, and so forth should be conducting this analysis even in the good times. Management should always know where the business makes and loses money. It should not be a last-minute rush to find out these things only when the bank account is running dry.
So the main takeaways from this episode are to review costs at the cost object level, and take out entire cost objects to save money.