Randal Suttles, B2B CFO®
Providing CFO services in Franklin, IN and surrounding areas

As I was reviewing the monthly financial results with one of my clients, we spent a great deal of time analyzing the gross margin. She asked me to do a training session with her and her key managers so they could better understand how to improve it. What follows is a brief, and hopefully simple, summary of our discussions.

You can improve profit only 4 ways (there are really 5, but I will get to that at the end).

You can raise the prices of the items you sell. Number 1. And this has a 100% improvement to profit. For every extra dollar you charge, you make another dollar. Simple.

I once missed a financial exam question that asked which has the quicker and greater impact on profit: higher prices or more volume? I picked volume. My logic was you cannot raise prices without volume, because a price increase on no volume is still zero. I got the answer wrong, but you know, I was partly right. You can increase volumes to raise profits, even without a price increase. That is Number 2. But, therein lies the tension that owners and managers face: how much volume do I lose if I raise prices? But the math is the math. Raise the volume at the same price levels, and you will make more profits.

Number 3 is to reduce the cost to make or manufacture. That means reduce manufacturing labor costs, material costs, and overhead costs. These are all topics for other discussion. But again, the math says if you can reduce the costs of what you make, you make more profit.

Number 4 is also cost control: reduce general and administrative costs. Administrative salaries, rent, office costs, computers, benefits, and so on.

Those are the only 4: Increase sales prices (number 1). Increase sales volumes (number 2). Reduce costs to make (number 3). Reduce administrative costs (number 4).

About the 5th way? That is balance sheet management. Control the accounts receivable levels, reduce inventory balances, manage accounts payable, tighten capital expenditures, limit debt levels and lower interest costs, etc. All of these are asset and liability management that impact profits. But for strictly managing operations, there are only 4 things to work on. Simple to describe. Hard to do.

In my newsletters, I typically write relevant stories of actual events that have happened to me.  Stories that give lessons that my clients can use.  Stories about what has happened on audits, and with working with my clients to solve their financial problems, dealings with banks, regulators, botched accounting systems…And I get positive feedback from scores of people.  They love the stories.

This letter is a bit different but tells a story too.  I think it very important to periodically explain and remind my contacts how I work with my clients.  Below is just part of the story of:

In the beginning:

With the owner and relevant staff, I conduct a free, no obligation review of the company’s financial information and systems.  I attempt to learn what are the problems and potential ways to solve them.  I prepare benchmarks against industry relevant financial averages.  And I create a confidential report of the findings.  Then:

I meet with the owner to discuss the results of the “Discovery Analysis” ^TM.  We review the key findings.  Most of the time the owner is well aware of what I identify, sometimes not.  We then discuss the areas in which I might be of assistance, the time line, and we agree on proposed costs.  Often times, this report, the “Strategy Gameplan” ^TM, is all that the owner needs right then.  Most of the time though, after we have agreed on the scope, timing and cost of the anticipated work for the near term, we shake hands (because there is no signed contract) and then comes:

The “Strategy Implementation” ^TM phase of the work.  Here I work on the agreed tasks.  I work with company staff (I have none of my own) in order to keep the costs down and get the work done as quickly and efficiently as possible.  This ”Strategy Implementation” ^TM phase can last as little as a few weeks, to more typically a few months.  As one of my clients said:  “You clean things up”.  There are generally tangible results:  refinancing complete, cash flow improved, financial reporting sped up and more accurate, but most importantly there is relief to the owner.  That is when:

I review the results with the owner.  We discuss the financial impact of the work so far.  But more important, we review the impact on the owner, the staff, and the company generally from the improved cash flow, financial position, better reporting.  But, the results are not all tangible.  Owners talk about “relief from the pressure”, more time to focus on growing the business, more time to strategize, better relaxed.  All see different positives, but “relief” is the common theme.

Following these initial phases of work with the owners, we discuss my ongoing involvement.  I tend to serve on a long term basis with my clients as their long-term trusted business advisor.  As one of my clients said:  “I want you involved.  Now that it is fixed, we need to keep it that way.”  And we move on together to grow the Company with financial and goal clarity and much relief.

That is a quote from one of my clients.  He and a partner own a very successful manufacturer.  As you might imagine, there are many issues:  sales and marketing, finance, employee relations, engineering, OSHA and EPA compliance, etc.  All are important, and if not done right, can cause immense problems in any business.  But he said “I do the purchasing”.  That is the critical core function that if not done right causes more than just problems, it causes failure.  He had picked out and is personally in charge of the mission critical piece of his business.

The owner of another client, also a manufacturer, approves all capital expenditures.  Not just the big ones, all of them.  That is the cash flow critical piece of his business. Large or small capital expenses for unneeded or overpriced equipment could break him.  So, he personally handles that.

Another client handles all employee recruiting.  Personally.  Her business is to provide professional nursing services on long term contracts to manufacturers throughout the US.  Her mission critical work is to make sure the nurses meet her standards.  So she hires all of them.  Personally.

One more.  A long time friend of mine who manages fixed income securities for clients all over the world said to me he does 2 things (ok so it is more than one, but you get the point):  “I work with my clients and I decide what we buy and sell.”  All of the rest:  compliance, data processing, employee relations, reporting, etc., is managed by others.

Indeed, non core functions need to be well handled.  But the successful entrepreneurs know their critical core functions, and that is where they focus their energies.  It works.

A bit of background first:

In my early career, fresh out of the University of Notre
Dame, I worked in public accounting for 7 years.  The first 3 years with Peat, Marwick,
Mitchell (one of the “Big 8” at the time) and 4 years with my father in his accounting
firm.  We were the largest local CPA
practice in Indianapolis at the time.
The Firm’s name was Fowler, Suttles & Co., named for my father and
his partner, Hugh Fowler.  Not only were
they business partners, they were close friends.

I was at one of my current B2BCFO^® clients this
morning.  This client of mine is owned by
the second generation in their family.
The first generation was a client of my Father’s, and of mine, some 30+
years ago.  The lady who processes
accounts payable is still at this client, as she was back then.  I noticed this morning that there was a very
old poster tacked to her cubicle, that she had obviously received from my
father, and had treasured all these years.
A bit tattered to reproduce, so I type the words here (capitalization
and format are same as original).

Fowler’s Laws

                In Any Field of Our Endeavor,

Anything That Can Go Wrong,

Will Go Wrong.

Left To Themselves, Things Always

Go From Bad To Worse.

If There is A Possibility of Several

Things Going Wrong, the One That

Will Go Wrong Is the One That

Will Do the Most Damage.

Nature Always Sides With

The Hidden Flaw.

If Everything Seems to be Going Well,

You Have Obviously Overlooked

Something.

Suttles’ Law

                FOWLER TENDS TO BE OPTIMISTIC

I guess if you work in the finance side of business, numbers are important.   So are formulas.  So here’s one:

In words:  What I spend divided by what I make equals what I need to sell.

In short hand:  $ out/margin = breakeven.

This is the breakeven formula that every small business owner needs to understand.

The numerator is the fixed expenses.  They include rent, loan payments, utilities, repairs, and salaries.  Note the fixed expenses include salaries, at least they would in my formula.  Owners and finance people believe that by definition salaries are not a fixed expense, they are variable and can be reduced if business slows.  But, that turns out not to really be true.  Unless business volumes fall off a cliff, owners are very slow and reluctant to cut staff, reduce hours, or cut wages.  Economists call that sticky.  Wages are sticky and don’t go down.  Even in this last worst recession, owners held off cutting staff until they had to.  So, I include salaries in the fixed expenses, at least for short term (4 – 6 months) planning purposes.

The denominator is a percentage.  It is the gross margin percentage.  Example:  If for every $100 in sales, material costs are $60 (60%), and sales commissions are $20 (20%), then the margin is $20, or in percentage 20%.  True variable costs are also sticky; the % moves slowly.  It is hard to cut commission percentages to the sales force, it is hard to reduce material costs a lot.  So, I treat variable costs as sticky, again in the short term.

So, here is the example:  If monthly overhead (salaries included) is $100,000, and the margin is 20%, then the monthly sales breakeven point is $500,000 ($100,000 divided by .2 = $500,000).  You need to sell $500,000 a month to meet the monthly expenses.

 Move the margin up by 5% to 25%.  That is a 25% improvement in the margin (5% divided by 20% = 25% relative improvement).  The breakeven sales level moves down 20% to $400,000 ($100,000 divided by the new margin of .25).

Move the expenses down by 25% (the same improvement I assumed in the margin) and the breakeven sales level falls to $375,000 ($100,000  original expense level reduced by 25% becomes $75,000 divided by 20% [original margin]).  So, you get more bang for the buck by moving the fixed expenses down.  So, focus on the expenses first.

A little of both:  move the margin up by 2% (relative improvement = 10% [.02/.2] and drop the expenses by $10,000 (10%) to $90,000.  The breakeven sales level is now $409,000.  Pretty close to the $400,000 in the formulas  where I only moved either the expenses or the margin, but I had to move them 25%, not just the 10% when I move both a little.

Both moves are hard to do (cutting expenses or improving margins) especially in slowing economic times.  But, in these examples, which is more achievable? Moving the margin or the expenses by 25%, or moving each by 10%?

Owners and their accountants pretty quickly figure out, life is better if we deal with both sides of the formula at the same time.  It is hard to move sticky numbers, so it is easier to move each a little.

Years ago one acquisitive entrepreneur I worked for (he purchased many, many companies and is now on the Forbes 500 list) refused to consolidate the operations once acquired.  That is generally opposite of what most buyers do.  Usually they try to combine and consolidate computer systems, staff functions (think personnel, legal, accounting, etc) and generally seek to reduce the overall costs.  He did not consolidate.  He said, indeed,  he wanted to make each acquired company more efficient, but it had to stand on its own, so that if he ever needed to throw it overboard (generally by selling it, but sometimes liquidating it) he could.  No anchors to weigh down the rest of the companies.

One of my clients purchased an expanded manufacturing plant, with lots of borrowed money, a few years ago.  Business fell off and the company is now facing oversized debt payments for the building, which is now too large for the company.  Given the layout, some of the space can be sublet, but not all.  The building and its debt have become an anchor.

Another of my clients has several long time, well paid, employees who are no longer fully needed.  Their expense has become an anchor to the business as well.

Another owns a number of specialty vehicles and trucks that he does not wish to sell.  After all, when business picks up, we’ll need most of those trucks.  Anchors.

To be successful, or reverse losses, some of the solutions are not pleasant, but the anchors must be tossed overboard.  Sell the building and take the losses, terminate the excess staff, part with the excess equipment, etc.  Most of the time it is more emotional for the owner than it should be.

But, the anchors must be thrown overboard, with no rope.

3 true stories.

Story one.  Many years ago, when savings and loans still existed, I audited several.  One of my clients was a small rural savings and loan that only lent money for residential homes in their and surrounding counties.  One year I began the audit as I always did, and asked to see the new loan register for the year.  I was told by Lloyd, the president, that they made no home loans that year.  Zero.  I said you have got to be kidding.  That’s all you are in business to do.  He told me that he could not understand how the S & Ls locally and indeed all over the country were making loans at 8% by borrowing large amounts from money brokers.  Even though the borrowing rate was lower than the 8% he could lend at, if he could not borrow at passbook rates of 5.25% and lend at 7.25%, as he always had, he would not do it at all.  I paraphrase Lloyd:  “I can’t figure out how they are doing it and expect to continue it.  So we [his savings loan.  He viewed it as his, although it was a mutual company, to him it was his.] are not going to do it.”  We all know what happened to the entire industry.  Gone.  The hot brokered money ran, and the real estate market collapsed in the early 80’s.  Turns out Lloyd was spot on.  He merged with a successful local bank, the officers, directors, and the depositors came out fine.  Lloyd didn’t understand it, so he didn’t do it.

Story two.  For many years I worked with a classic hard charging entrepenuer.  He never met a market he did not wish to enter and conquer.  We were presented with the opportunity to invest in, or buy 100% of, a multi state radio station that was trying to build a national niche as a multi-market provider of local news.  Lots of issues involving sales, market size, advertising revenues etc.  But a unique concept.  Bear in mind this entrepenuer never met a market he did not wish to enter.  I already said that, didn’t I?  We hired a radio station “consultant” and went and did our due diligence.  Historic financials, market studies, cash flow projections.  Typical due diligence drill.  This man really wanted to buy these stations.  Finally, after much angst, he said to me (again I paraphrase, but this is really pretty close):  “When I lie down for a nap and think about the radio stations, I really want to get in that market.  Then I wake up, the feeling passes,  and I think I don’t understand how we can do that.  The market [local news delivered nationally] doesn’t make sense to me.”  So we took a pass.  Saved our money.  The stations went broke.

Story three.  One of my clients had been in the steel fabrication and contracting business for years.  He had been generally successful.  They would quote a job to erect a steel building, buy the steel, and do the construction.  Good profits.  For years.  Then it tanked.  Steel prices went through the roof, but the contractors were still bidding low and low balling one another.  Big losses.  Within just a few months, after 20+ years in the business, my client shut it down and auctioned off the property and equipment.  He made that move with lightning speed, especially considering how long he had been in the business.  I asked him about it.  Again paraphrasing:  “I could no longer figure out how to make money in this business [the construction and contracting side of steel buildings].  But I could figure out who always made money – the steel fabricators (the wholesalers who bought the steel, cut it, and delivered it to the contractors).  Whether the prices go up or down, they just pass through the steel price and make money on the fabrication.  So that’s the business we are going to do.”  He took the proceeds from the liquidation plus some lines of credit, began and built over the next 30 years what is today one of the largest and most successful steel fab and distribution businesses in the Midwest.  He did it because he could no longer understand the business he had been in.

Lesson learned:  If you can’t figure it out, you might be better off not doing it.  When you can’t compete on price, or logistics, or labor costs, or whatever, maybe there is good reason you can’t figure it out.  It just might not work.

Most of these writings of mine have some kind of theme or particular point.  This one does not.  It is just two stories about one of my long ago clients.

 The client was a trucking company.  They were a very large long haul trucker.   Given their size, they were self insured for property damage claims to their own trucks and for the products they hauled for their customers.

 I was at the office that handled the claims for my client one day in December.  In Indiana.  It was cold, icy and snowy.  The manager of the unit picked up the phone and took a call from one of their drivers.  The driver was fine but had been in a major wreck.  He had been hauling a load of new cars from Detroit to a dealer in Ohio.  He was passing through Fort Wayne, Indiana going downhill (probably too fast) hit the ice and flipped the truck upside down.  No injury to him but literally smashed the cars, all 8 of them.  The manager asked the driver what kind of cars he was hauling.  As you can probably guess, not small cars, not small pickups, not even mid size cars.  He was of course hauling brand new Cadillacs.  Total loss.  Always the worst possible outcome.

 Same client.  Same winter.  Two months later.  Now February.  Lots of snow and ice.  I was at the corporate office in Kokomo, Indiana.  Their office was in an old flat roof converted warehouse.  Three stories tall.  There was so much ice on the roof (several inches frozen solid) that the roof had begun to creak pretty badly.  Given the age of the building, everyone was concerned about a collapse.  So they sent two maintenance workers to the roof to clear off the ice.  No instructions though, just get the ice off the roof.  They did.  Roof stopped creaking.

 …..Two months later, spring in Indiana and it is raining buckets.  I am at the same office and water is pouring through what must have been 100 small holes in the roof.  Care to guess how they cleared the ice?  Pick axes of course.  Right through the ice and holes in the roof.  Always the worst possible outcome.

One of my clients is a job order manufacturer for the auto industry.  A few months ago they were having difficulty meeting delivery deadlines.  As they tried to meet deadlines quality began to slip, more deadlines missed…  You know how it goes.  They needed a way to fix the shop scheduling problem,  to meet ever tighter deadlines, while holding to their quality standards.  Or the customers were leaving.

I was asked about computer software to help fix the problem.  I balked.  I told my client that if you cannot figure out what is causing the problem and solve that, then if you automate it, you will just get the same problems, only faster.

Years ago when I was CFO of a health insurance company, we targeted to pay 90% of the claims in 5 days, 98% in ten.  We were failing.  We had grown too fast and could not keep up.  Our solution:  colored folders.  Every day of the week was a color.  From my memory:  red for Monday, yellow for Tuesday, blue for Wednesday and so forth. You get the idea.  Every claim received was put in the appropriate color of the day.  So on Friday, every claim file in a yellow folder was on day 4 and needed to be done by Monday.  End of day Friday, anything still in a yellow folder was transferred to a black folder and they got priority.  It took some time, but daily monitoring of the colored folders by the adjusters and their supervisors caught us up.  In a few months we met our time service standard.  Note this was 25+ years ago and predated most automated computer systems.  It was a manual solution.

So we tried something similar at my client.  We have about 200 jobs in shop at any point in time.  Each job will have an engineering/machining spec drawing on it.  The deadlines are generally five days for each job.  We assigned every week of the month (not day, but week) a color.  So, the machine operators know by color in the folder (we used different color sticky notes, and wrote the exact due date on the sticky note and stuck it in the job folder) which jobs to work on first.  And, since many of the jobs can be handled by different machine operators, they know by color which operators they can help complete the jobs.  The machinists and supervisors solved the slipped deadlines themselves, just by focusing on the colors.  We went from almost 50 out of 200 late deliveries to only 2 within 2 months.  All we did was use colored folders.  Months after implementation, we are still current, still using colored folders and have not yet automated it. 

As the engineers at our customers are noting our timeliness and much improved quality, they are sending more work our way.  We will eventually have to automate the “colored folder” process as our volumes grow, but the idea will be the same.  Highlight the deadlines and let the supervisors and work force solve the problem.

Some years ago, while I served as CFO of a mid sized health insurer, we spent several thousand dollars to air ship in a computer from Texas.  Why would anybody do such a thing?

Here is the context:  We had grown so fast that our data processing systems could not keep up.  Not the software, nor the hardware.  We were unable to timely process health insurance claims, by a lot.  Everyone was working extremely hard to try and keep up, but the hardware (printers in particular) could not keep up with the volume.

The Chairman was angry, to say the least.  He wanted to know what management was doing about it.  I clearly remember the meeting with the manager of the payment department.  He had lots of excuses, including lack of staff, lack of computer tech support, lack of this, lack of that.  “Not my fault!”  It was clear though, that the manager was making excuses.  Although there were indeed difficulties, there just was no sense of urgency.

The Chairman asked what it would take to fix the hardware problem.  The department manager indicated he needed a new printer (10X faster than the current printer) that was compatible with the software.  It was a rather unique printer, available in the aftermarket, and he had located one in Texas.  He said they would purchase it and we would receive it at our Indianapolis offices in 3 weeks.  Shipment via truck.  The Chairman was incensed.  He ordered the printer air shipped in, two days.  We spent thousands to deliver a message.  There was to be no excuse for failing to solve the processing problems.  It wasn’t so much the cost to fix the problem, it was the lack of urgency.

We got current with the claims payments pretty quick.  Not because much different was done, but there was clearly now a sense of urgency.

Much of the time, the most important message is the example you show the staff.  The Chairman gave a clear example.  That department manager left the company soon thereafter.  Two different approaches.  Excuses or urgency?