Wednesday, April 4, 2012

Austerity Never Works; But Cost Containment Does. Know The Difference.

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We recently discussed the notion of Breakeven Analysis, and actions of increasing contribution margin (price less variable costs) per unit; increasing the number of units sold, and trying to reduce fixed costs (our minimum hurdle) without injuring the profit-producing mechanism.

Nonproductive fixed costs are purely wasteful and they accumulate in the business budget like dust over time. Productive fixed costs (those costs which are in some form or fashion related to or necessary to the production of revenues and/or the production of the business' product or service have to be separated from non-productive fixed costs.

If we try to eliminate a productive fixed cost, we will damage our business - perhaps irreversibly. If we take the time to cull out all of those non-productive business costs, we will reduce our breakeven point and increase our potential possibility.

Cost containment is the key to success at this surgical trimming.

It begins with evaluating a proposed expenditure or expense in terms of "Is this necessary? Will it increase revenues or reduce other costs? How long will the anticipated additional margin of profit take before we recover the capital cost of this 'thing'?," i.e., a large piece of machinery, a new building, a new information or communications system. A rudimentary ROI or cost recovery analysis must be done before undertaking a new cost on a whim.

It continues, with an ongoing periodic re-evaluation (remember zero-based budgeting?) of each of these costs and whether each is actually necessary and/or productive. If it is not necessary and/or productive, find a manner of eliminating it. A renewal of a fresh perspective is necessary.

Austerity, as a general policy, generally just de-motivates people, and makes their work less rewarding and more challenging. It sets a philosophy of mitigating losses instead or increasing profits, and puts in place a psychology or shortage instead of abundance. A blanket policy of austerity is not remotely the same as prudent, diligent cost containment.

Broad brush austerity doesn't help a business, and it has never turned a failing economy around. Most people immediate associate the very term "austerity" with damage control or slowing down an inevitable failure -- cost containment, by way of contrast, is a means of finding "lost" money and increasing ongoing profitability.

More follows from an article which I co-authored about Critical Factors Needs Analysis ("CFNA") with Bruce Newman of the Productivity Institute, LLC in 2009. It's wisdom is applicable today as it was then. If it makes you more comfortable, CFNA is merely a methodical philosophy and system of cost containment.

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Every business generates its profits, subject to the same basic methods and constraints - regardless of the nature of the products it sells or the services which it renders.

It takes in revenues from sales or service activity, pays out variable costs, meets (by paying) its fixed cost obligations, and ends up with either a pre-tax profit, or a pre-tax loss. In a Not-For-Profit organization, the same dynamics apply, but the nomenclature is different: they collect contributions or donations (in lieu of revenues), and pay out variable and fixed costs. For the purposes of this article, we will address all organizations as if they functioned in a For-Profit environment.

The objective of every going concern is to collect more money than it pays out. Simply put, this means maximizing revenues and minimizing costs, thereby increasing the spread.  As business organizations evolve, they become so filled with complexities, diversions and conflicts, that they lose sight of these simple basics.

There is a need to re-evaluate these business basics periodically – to take a fresh look at the business of the organization instead of at the entire organization as a socially complex entity with a variety of objectives, many of which conflict with or constrain profitability. Stripped of all these factors, one can examine the inherent profitability structure of the business.

At the risk of being politically incorrect, and of sounding callous, CFNA™ (Critical Factor Needs Analysis) does not focus any of its energies on corporate citizenship, environmentalism, jobs creation, and the like. CFNA works precisely because it deliberately eliminates all of these largely qualitative factors from its evaluation approach, working to effectively evaluate a corporation’s well-being and make accurate recommendations.

CNFA also looks at cash inflows and outflows, rather than theoretical accounting constructs such as accruals, amortization and the like. These are good tools for properly matching expenses to the revenue-generating process, but they are not representative of “in the trenches” reality.

CFNA™ does not delve into the world of best accounting practices.
The thought here is that substantial stakeholders and directors must understand the nature of a) their market, revenues, price sensitivity, and contribution margins, and b) the structure and nature of their fixed costs.   People are not in business to cover overhead – especially accumulated, non-productive “legacy” overhead.  Rather, they are in business to generate profits by exerting control on every possible and reasonable variable.

Another important thought is that, generally speaking, the more established a business becomes, the more fixed costs are perceived as if they were actually the bottom line – especially where matters of personnel costs, perquisites, esthetically-pleasing offices and other categories of fixed costs are seen as compensatory to some of the business’ management. These fixed costs begin to take over the priority position of actual profits. Companies begin seeing revenues as a way to merely subsidize continued wastefulness or excess.

How businesspersons look at business

Businesspersons have several ways of looking at business, and these mindsets ultimately will affect potential profitability. Here are the several different “schools” of thought:
  • We have high fixed costs. We have to generate enough contribution to cover them. We had better generate enough cash flow to meet these “given” costs. Bottom line: We work to pay fixed costs.
  • We have high revenues. We don’t have to monitor fixed costs too closely…in fact we can afford the luxury of a growing fixed cost threshold as we become a bigger revenue-generator. Let’s get bigger offices. Let’s get some corporate aircraft (to make a good impression when traveling to meet financiers and [gulp] legislators in Washington, D.C. Life is good. The business should exist to support our improved standard of living (e.g., our growing fixed-cost structure). Bottom line: We will continue to generate increasing revenues, so fixed costs (even a bit of excess) will not hurt us.
  • We have to make a profit. Let’s keep the fixed costs to a minimum just in case revenues take a dive. In fact, to be conservative, let’s accumulate some reserves of liquidity in the event that revenues decline significantly. But whatever we do, let’s not get obligated to a high contractual fixed-cost structure. After all, every dollar that goes toward paying off fixed costs would be better if it could be part of profit. The lower the fixed cost threshold, the greater our profit. Bottom line: We should minimize our fixed cost structure, so that we have latitude if revenues decline, and increased profits if revenues increase.
Each of these schools of thought actually exists, but the CFNA™ evaluative model requires that we think in the third way. Fixed costs must continually be evaluated and controlled – especially if we are in a business where:

1. Our product or service is price-sensitive, and we must be prepared to cut prices (and decrease revenues) in order to compete in our marketplace. We are not a monopoly, and cannot exert pressure on prices. Revenues are sensitive, and only partially under our control.

2. Our product or service is considered a luxury or discretionary expenditure by our client or customer base, and we may sell fewer units (and decrease revenues) if market demand decreases. Revenues are sensitive, and, price notwithstanding, are not under our control if the economy turns downward or if our product loses its market share, or market desirability.

3. Our contribution margin is thin (the price per unit is not much greater than the variable cost per unit). Revenues are doubly-sensitive, in that if we lose either some sales, or if prices drop, we will be victimized.

4. Our profit is significant.  However, because of market factors – including increased costs, an economic downturn and/or increased competition, we might not be able to maintain this margin – which can quickly decrease.  To maintain this cushion and not be victimized, we must maximize profits and remain agile.

The thought here is that substantial stakeholders and directors must understand the nature of a) their market, revenues, price sensitivity, and contribution margins, and b) the structure and nature of their fixed costs.

We are not in business to cover overhead – especially accumulated, non-productive “legacy” overhead. We are in business to generate profits by exerting control on every possible variable upon which we may reasonably do so.

Another important thought is that, generally speaking, the more established a business becomes, the more fixed costs are perceived as if they were actually the bottom line – especially where matters of personnel costs, perquisites, esthetically-pleasing offices and other categories of fixed costs are seen as compensatory to some of the business’ management. These fixed costs begin to take over the priority position of actual profits. Companies begin seeing revenues as a way to merely subsidize continued wastefulness or excess.

Conclusion

We cannot heal until we know that we are ill, and until we understand the nature of the illness. In all circumstances, objectivity is required, fixed costs must be perceived as an enemy, and not as a hurdle to be met, or as a target objective. This pattern of thinking and associated conduct leads to a mere “breakeven” or “minimal survivalist” conduct that destroys companies. Companies are not in business to cover overhead: the core objective is to be profitable – in both the short and long term, for without profitability everything else becomes merely academic.
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The key to business success is not to merely cover increasing costs -- it is to ceaselessly innovate in order to generate increasing profits. Cost containment is a part of profitability process, but not quite as high on the consciousness priority list as increasing sales revenues and profit margins.

Douglas E Castle for The Business And Project Planning And Management Blog




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