Ask Score: The Two Worst Mistakes a Manager Can Make in a Slow Economy
The Two Worst Mistakes a Manager Can Make in a Slow Economy
And an Alternative Approach to Yield Sustainable Sales and Profits
Managers make two serious mistakes in a slow economy, such as we have today in many industries (other than energy). They are: 1) cutting prices to stimulate business, and 2) cutting costs through layoffs. There are much better ways to maintain and grow profitable business even in these times. What follows is a prescription for success by simultaneously improving sales and profits at any time.
The first step is to change focus from selling price minus cost equals book profit to value added minus cost equals sustainable profit. Conventional accounting systems gather data on all product and service costs, including materials, labor and overhead and then add a profit margin to arrive at a selling price. This system leaves the firm vulnerable to competitive pressure on price which only serves to reduce profits when prices are lowered.
A better approach is to focus on value added, which means that the costs we are concerned with are those which are added to materials, and excluding the cost of the materials. Obviously, materials costs will have to be added later when costs are totaled, but for the moment, we must focus only on the value which is added after the materials are purchased. The more value added, the better. The lower the material cost as a percentage of total cost, the better. Value is added through labor, and the type of value added must be according to real customer needs. When the firm adds value that customers perceive as important, value is a more important buying determinant than price.
The second step is to focus on cost reduction through productivity rather than across the board reductions. Every element of cost is ultimately justified through its productivity in adding value. This can be accomplished through the use of a tool we call ratio budgeting coupled with sensitivity Analysis. (RBSA).
Every element of cost including materials, labor and overhead is measured in its ratio to sales price by product or service lines. The ratios then form the basis of a productivity improvement effort focused on reduction of the ratio through productivity gains. Gains are made through improved performance tracking, more effective purchasing procedures, training, process improvement and quality management. They are traced through periodic review of the starting ratios versus current ratios measured against goals. The power of this system might be demonstrated by a simple example.
In a business with sales of $2,000,000 annually, with labor costs of $500,000 (40% of sales), a 2% reduction in labor costs through improved productivity would produce an improved profit of $10,000. A 10% improvement would lower costs by $50,000.
These two management systems, refocusing on value added to develop and maintain sustainable sales and profit levels, and a new emphasis on productivity improvement through Ratio Budgeting and Sensitivity Analysis can go a long way toward enabling profitable operations regardless of the economic slowdown.
Richard Walton, Counselor for SCORE, and President, Enterprise Resource Management Associates, Inc., of Hagerstown, Maryland. Cell phone: 301-462-9850, email: firstname.lastname@example.org.