Manage that financial belt…or it will get you!

by Guy Ralfe on July 15, 2009

tightening-budgetsEntrepreneurial business ventures have the same business concerns as their conglomerate competitors – they all want to turn a profit. They want their revenues to be significantly larger than their costs.

Keeping it simple, to increase profit we have two approaches:
~ increase our revenues relative to the cost
~ reduce our costs relative to our revenues

During times of economic prosperity companies often deal with challenges associated with growth, in their operations, by sacrificing operational efficiency. Typical examples are acquiring equipment when we expand our orders rather than reworking the scheduling; hiring additional staff rather than reorganizing the process.

I will use an example to simulate a company going through a growth and contraction to highlight the effect:

A sample company produces 1000 widgets per month at $5/piece, produced by 2 machines costing $2,000/month each. Throughput is 500 units per machine.

Through economic prosperity, production increases to 2,000 widgets per month, however this production requires 5 machines because along the way as each successive machine is acquired, the sudden capacity relief resulted in a decline in efficiency. This efficiency is not regained as you approach each successive machine capacity limit. Throughput is now 400 per machine.

In a market contraction,  production reduces back to 1,000 widgets. This is half the peak value so the machines scale back at this new throughput rate of 400 units per machine (1000/400=2.5) This requires 2.5 machines which we obviously can’t have, so now we need 3 machines to produce our 1000 units per month.

If we look at these three scenarios from a profit margin point of view (below) the accumulated inefficiency during growth has a drastic effect on the profitability when operations have to be scaled down. This example used machines but the same concept applies to all resources.

chart numbers

Going back to the factors that influence profitability, this translates into value, which is what we are prepared to pay for items:

  • the value produced for customers through product offerings – this will preserve the revenue side of the equation through both expansion and contraction.
  • the value to the organization of resources (assets, employees, cash) – cost is the component that seems to creep out of hand quickest and can be difficult to reign in again once you have established a lower value to the organization. This usually shows up in falling utilization (% of productive time) and realization (% of potential revenue)

The market is cyclical and the challenges faced in prosperity are the same that will haunt you during contraction. So as your business grows, pay attention to which notch you keep the belt on!

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