Proactive change

2007-11-20 00:00

Now it doesn't really matter how accurate the predictions are, there is a fair amount of smoke around and we know there's never smoke without fire. This is the perfect time to take a close look at what you are doing, with a view to making what you do a little easier and possibly even more successful.

Today and next week, I am going to look at how to put new strategy into your business that can accommodate a market turndown, while making your business more profitable.

Let me start by presenting an assumed business with which to demonstrate and develop our strategic objectives. “MyCo” is a manufacturer, employing 23 people with an annual turnover of about R7,5 million. Overheads are running at about R2,3 million per annum plus interest charges of R72 000 p.a. The current gross margin percentage is 40%, which produces about R700 000 a year PBT (profit before tax). None of these operating variables look at all bad, with MyCo's PBT level achieving a nine percent return on sales. However, if a market turndown is on the horizon, MyCo would still like to try and maintain its R700 000 profit level - how and where should you begin to develop your new strategy?

We need to start with setting out MyCo's operating performance against the break-even formula, which conventionally, has been defined as fixed costs (overheads) divided by the gross margin percentage, which will produce the turnover required to break even.

However, I prefer to use a modified break-even expression of: Fixed costs plus interest costs, divided by the gross margin percentage, produces the level of turnover required to break even. MyCo's current operating performance would look like this:

Fixed Costs + Interest = turnover to breakeven

R2,3 million + R72 000 = R5,93 million

Gross margin % 40%

We want to reduce the break-even level of MyCo, while maintaining the current rand value (R700 000) profit. To begin the process, you should examine every cost line that makes up your R2,3 million annual overhead number. Your objective is to find every cent you feel is not adding real value to your business.

The second step will be to produce your best possible guesstimate of the turnover value you believe you will lose. For instance, you could feel that R1 million is vulnerable and could be lost in the coming year, meaning MyCo's turnover could fall as low as about R6,5 million p.a. Bearing in mind our objective, what we are saying is that R6,5 million needs to produce R700 000 PBT in 2008.

Returning to your analysis of the MyCo's overhead, it may be feasible for MyCo to reduce its existing cost base by R200 000, to R2,1 million. I suggest that the interest cost be held at R72 000 p.a. for the coming year. Should this in fact fall in 2008, it would simply make the overall objective that much easier to achieve. We now have the top half of your new strategy's formula in place, thus:

R2,1 million + R72 000 + R700 000 = R6,5 million turnover

You will see that I have extended the break-even formula to include MyCo's required R700 000 PBT. If we add the fixed and interest costs to the required PBT, what needs to be asked is: “What gross margin percentage do we divide this sum by that will result in a about R6,5 million turnover level - the new strategy turnover level for 2008?” The answer is, of course, 44%, which means that the new strategy calls for MyCo to find four GM percentage points' improvement. I will look at this particular objective again in detail next week. By increasing the gross margin percentage from 40% to 44% and shedding R200 000 of overhead, MyCo can afford to lose R1 million turnover, yet make the same profit. I suggest this is a pretty good change to make!

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