Let’s recap the scenario my colleague Robert Green created in the first article in this series. You’re the owner and CEO of Allright Widget. You founded Allright in 1981, and over the past 10 years Allright has grown from the ground up to become a $15 million business that makes widgets for commercial and military use, with a building you own in Chatsworth. Like most business owners, you’re often overwhelmed with pressures from employees, vendors, customers, sales representatives, and regulatory hassles and the constant question in your mind: “could Allright be doing significantly better? And if yes, why aren’t we?” In this installment we’ll explore the financial side of the business. You know, the part that tells you whether or not you achieved the profit that makes it all worthwhile. Unfortunately, sometimes the business doesn’t deliver a profit, or at least not the kind of profit you think you should be getting for the effort you’re putting into it. When you raised the issue with your management team, they had the following suggestions: – Your sales manager thinks you should lower prices so she can sell more, – Your plant manager thinks you should borrow money and acquire the latest technology in manufacturing equipment in order to boost productivity, – Your controller thinks you should cut costs so that you spend less (although he may not be clear on where those cuts should come from). You know in your heart that none of these strategies is the magic bullet, but you don’t have any good supportable answers of your own because, as we noted in the last installment of this series, you’re so busy working IN the business you haven’t the time to work ON the business. Let’s see if we can help to focus your thinking. Many salespeople would rather see lower prices because it makes your widgets easier to sell at least if they’re selling price and competing on price. But that strategy without careful thought can seriously dilute gross margins and damage the company’s profits irretrievably. Competing on price will eventually reduce your widgets to a commodity where only the lowest price wins. A better idea: Most surveys of customer buying motivation put price down the list of reasons buyers buy, after things like quality, reliability and service. Selling the attributes you are most proud of in your product and teaching your sales force to sell those attributes is a much more profitable way to go with far less risk. As for proper pricing, there is a concept in financial accounting called Contribution Profit, which is roughly equivalent to selling price less direct costs of production and less dedicated indirect costs. It represents the actual contribution to the company’s bottom line that comes from making a sale. Until you know that number, approach any sales price reduction with great caution. A good plant manager will want to produce the best product possible, with the highest productivity and the latest equipment. They will not typically grasp the amount of profit improvement or time it will take to pay for that expensive new equipment, and in honesty that’s not an analysis that you would expect to roll off the tongue of your plant manager. But if you can’t get that analysis done by your finance staff you shouldn’t buy the equipment and your banker is unlikely to lend you the money in any event, because they want to know that answer too. A better idea: Effectively managing a capital acquisition program for your business requires an understanding of Return on Investment (“ROI”) and its more advanced cousin Discounted Cash Flow (“DCF”). These tools will tell you whether or not that new equipment will pay for itself in 3 years, or 5 years, or 20 years (by which time you may not care). A comparison of what you’ll pay out with what you’ll save in productivity gains, adjusted for the time value of money, is the magic that should guide such decisions. If you know it, your banker will be impressed and likely glad to lend the money. If you don’t, your banker will try to estimate it for you, and will likely add something to the interest rate to compensate for the added risk of lending to someone who doesn’t realize how important such decision making tools are to your business. Controllers and accountants in general are given to recognizing the value of cost cutting. They will tell you that a dollar in added sales will add only a fraction of a dollar to your profits, while a dollar in cost reduction adds a full dollar to profits. And they’d be right. But that doesn’t make it always the right answer, and often it’s simply the wrong answer. Cost cutting solely to avoid spending money is likely to cause more damage than good because it’s focused on the wrong problem. Want a good example of bad cost cutting? A company in Allright’s industry had avoided replacing departing collection staff in order to raise apparent profits in preparation for selling the company under a profit-based formula. We replaced the staff with strong collection professionals and in short order improved collections so much that we added $5 million to the ultimate selling price. Gene Siciliano CMC CPA is an author, speaker, consultant and coach. His book, “Finance for Non-Financial Managers,” is available through bookstores and online. He can be reached at (888) 788-6534 ot www.CFOforRent.com
