The wrong way to fix things

2008-03-11 00:00

You will gather from last week’s column that I have been spending a fair amount of time up on the Reef. Well, I’m still here, knocking out my column from the quiet of my hotel bedroom.

Last week, I discussed the need to batten down the hatches. Those of you who read the item could not have missed the leader article on that day (March 4), underlining the fact that demand has slowed dramatically and that the purchasing index has reached a four-and-a-half-year low.

I have a great deal of sympathy with those organisations that have gone out of their way to reduce costs in an attempt to make their businesses’ structure more lean and hungry in these difficult times.

However, I have no sympathy for companies that find themselves in extremely difficult circumstances, not because they are experiencing difficult economic conditions, but because they have run their businesses poorly.

Let me paint you a business scenario. A large organisation, in its seventh month of the financial year, is facing a shortfall of top-line turnover against the budget. Management has caucused and a tactic to rectify the problem is put in place — or so they think.

The essence of the plan is to cut the price of many of the leading products and mount a formidable advertising campaign.

Let me underline the circumstances to ensure we get them right.

Year-to-date turnovers are below the budgeted level and the company’s profit objective will not be achieved. Put another way, there is insufficient turnover to realise the gross margin level necessary to recover all the fixed costs (overhead) and produce the required amount of PBT (profit before tax).

This plan will result in a reduction in the gross margin percentage because of the price-cutting and increased advertising that will push up the fixed costs.

Both these actions will have the effect of increasing the operational break-even level of the company.

At a time when there is insufficient volume to ensure that the required PBT is produced, management’s new plan calls for even more turnover.

What makes this even more ludicrous is that, most likely, the competitors are doing the same things.

Equally, the company has failed to realise that it is not just their direct competitors they are fighting against in times of economic turndown, but every company or market that is fighting to get the same R1 of disposable income spent with them!

I cannot begin to say how often I have seen this problem as I travel around the country. There are two elements that are the root cause for this operational inadequacy.

Firstly, the original budget probably called for far too much growth in turnover. Almost from day one of the new financial year it would have been an uphill battle to achieve the turnover number that would produce the bottom-line requirement.

The second contributory element is that not one of the management team in the business has understood the interrelationship of the major operating variables, nor the impact that their decisions have upon them.

The principal variables affected are turnover, costs of sales, gross margin, fixed costs and PBT.

The management’s tactic to rectify the situation of “cut the price and sell more”, is really little more than a gamble — and not a good one at that!

What they should have been looking to do, was to increase the gross margin — both value and percentage — and to reduce the fixed cost structure.

Success in either of these objectives would have brought down the break-even and made the existing turnover levels more profitable.

In respect of the gross margin, this operational variable can have a dramatic impact on a company’s profitability.

Instead of reducing prices, management should have looked for the complete opposite, a price increase to protect gross margin; secondly, coupled this with a reduction in the cost of sales; and thirdly, improvement in the product mix of sales.

Next week, I shall revisit these points and add a little more flesh to the bones that I have outlined here.

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