What is your Break Even?

I know a company president who goes around the office saying ‘our sales minimum target is $350,000, we gotta hit at least 350k’ over and over, out loud.  Where did he get the number from?  From a discussion with his CFO regarding his monthly break even point – the 350k is his break even.   This break even concept is part of a larger concept  commonly referred to as cost-volume-profit (“CVP”).   

So what is CVP?  CVP refers to the sensitivity analysis conducted to determine the revenue and profit resulting from  varying levels of production.   Sounds complicated, but really, it can be broken down into small, understandable pieces.

All companies incur expenses related to their sales.  These expenses should be segregated between variable expenses and fixed expenses.   For those companies that manufacture their own product, they incur material and labor costs directly related to the production of the item (call it a “widget”).  These expenses are variable, as the amount spent is dependent on the amount produced and subsequently sold.   Other expenses not directly related to the production of the widget are commonly referred to as either ‘overhead’ or ‘selling, general, and administrative expenses’.    Examples of these expenses would be office and administrative salaries, supplies, rent, legal and accounting expenses, etc.   These expenses occur whether or not the production equipment is running.   The total amount of the fixed expenses is one factor in determining the break even sales point.  The other is contribution margin (“CM”).

After the expenses are segregated, CM should be calculated.  The calculation for CM is simple – sales minus variable expenses.  This should be calculated on a per unit basis as either a percentage of sales or a unit CM dollar basis.  CM is important – it’s important to know how much each widget is ‘contributing’ to cover overhead expenses.  Therefore, the CM should be calculated for each widget produced.   The weighted average CM, based on the budgeted sales mix, along with the fixed expenses totaled above, will then determine the break even point.

To calculate break even, simply take the Fixed Expenses divided by the CM%.  So, if your business has $2.0M of fixed expenses and maintains a CM % of 35%, the break even sales volume is a little over $5.7M.  If you can make internal initiatives to lower fixed expenses and raise the CM%, the break even declines.  A 10% improvement in both the above numbers would result in a break even volume of $4.7M, a $1.0M difference!   For every dollar of sales over the break even, the CM% drops straight to the bottom line.  So in our original scenario, for every dollar sold over $5.7M, the company makes a profit of $.35.  Sales of $6.7M would generate net income before taxes of $350,000.

All of the above can be input into an Excel model and subjected to sensitivity analysis.  What if sales are 10% higher?  25% lower?  All easily reviewable scenarios with Excel.  Knowing your variable and fixed costs and therefore your break even allows you to stay in control of your business and make decisions to avoid a crisis.

Hope is Not a Strategy

I recently met the owner of a company, along with his daughter who functions as the Office Administrator.  While the owner works on generating new sales opportunities, his daughter directs the administrative and clerical staff, processes payroll, and handles other functions in the office.  Unfortunately for this family-owned business, the company struggles with its cash flow, and it affects how the owner and his daughter run the company; they often have to “rob Peter to pay Paul” in order to cover current obligations.  They had a high accounts receivable balance as well as an extraordinarily high amount of inventory, and their bank line of credit was nearly maxed out.  As we discussed their current cash flow situation, they acknowledged that their collective stress level peaks when it comes time to process payroll.  I specifically asked the Office Administrator what she does to plan for payroll and ensure that the company has enough cash to be able to fund it.  “I pray,” she replied.

Pray?  While I support the idea of praying, that alone is not going to solve their cash flow problems..nor their stress.  As we walked through his warehouse, the owner pointed out some of his inventory…some of which was over 10 years old!  When asked about the outdated inventory, the owner replied that he was holding out hope that a customer (a random customer no less) would want some of that inventory someday, and he wanted to be in a position to meet the customer’s request.  I’m thinking that if some of that inventory is over 10 years old, that hoped-for random customer is probably not going to be showing up any time soon.

Prior to 2008, business owners were able to go to the bank with a few financial documents and a great story about their company and be able to get a loan.  Those days are over.  These days, the banks are scrutinizing every applicant with a fine-toothed comb to determine whether to lend to a prospect.  It makes more sense and is more cost-effective in the long run for a business owner to manage and maximize the company’s working capital.  Doing so, however, is often the biggest challenge for business owners, but it also represents one of the greatest opportunities within a business to free up cash.

There are several things that this company needed to do to better manage and improve its cash flow situation:

• The first tool needed was a 13-week rolling cash flow projection; having one in place would enable the office administrator to plan more effectively for payroll and other obligations week by week, rather than rely solely on a higher being to make sure everyone’s paycheck cleared
• Get rid of as much inventory as possible, freeing up cash which can then be used to pay down the line of credit and buy inventory they could actually sell and profit from on a consistent basis
• Improve the overall billing and collection process.  Over 50% of the accounts receivable balance was over 60 days old, and it was evident that the company didn’t get invoices out on a regular, consistent basis, nor did they manage the outstanding invoices to ensure receipt.

By reducing the A/R balance over 60 days as well as inventory over 1 year by even 25% and 50% respectively, they would have nearly enough cash to pay off the line of credit.  Doing so would give them the breathing room they need, and an answer to the owner’s hopes & his daughter’s prayers.  Hope is not a strategy, but turning hope INTO a strategy can and will be effective.

Everything’s Either People or Money

I used to have a boss who was fond of saying that, in business, “Everything’s either people or money”.  It’s an interesting concept if you think about it.  His point was, anytime he needed to make a big decision, it was “Do I have the money to do it?” and “Do I have the people to do it?”  He figured he could buy darn near anything he needed if he had enough cash, but knew he couldn’t buy a loyal customer.  He knew that money alone was insufficient to win the hearts and minds of his employees.

If you focus on “people things” (having strong people on the team, treating people with respect, communicating with employees openly and honestly, etc.) and “money things” (having enough capital to run the business, pricing the product well, watching the bottom line, etc.) then everything else will take care of itself.

This is one of the three or four business concepts that have really stuck with me over the years.    Actually, I think it should be “everything is people and money”.  I’ve applied this concept in many circumstances.

1. Putting customers first…treating my customer like I would like to be treated and working to keep that relationship for the long haul.  Financially, it typically costs more to acquire a new customer than to keep an existing customer.
2. Providing adequate investment in things that enable the workforce…like recruiting the best talent, providing for regular training opportunities and supporting infrastructure such as an intranet that improves internal communication .
3. Negotiating with suppliers…not going for every last dollar and driving a supplier into the ground, but treating suppliers with respect and looking for win-wins and the opportunity for a long term mutually valuable relationship.

Lately, I’ve been talking to a lot of people about banking relationships.  And “Everything is people and money” hits the mark again.

Credit is tight, businesses are struggling more than they used to, and times are just generally tough.  I’ve seen a growing hesitancy for a business owner to be open and forthright with his or her banker.  Owners seem to want to “work through” some of the issues before talking to a banker, in fear that their credit line may be yanked or the relationship otherwise damaged.

Think about it from your bank’s perspective.  Of course, their first priority is “the money” – they want to get repaid.  But what about “people”?  Bankers understand and have witnessed that nearly every business has struggled the past couple years.  Character is more important than ever.  Banks know that businesses will bounce back.  If they have to take a leap of faith (and trust me, in this environment, they often do), who do you think they will take the leap with?  It’s going to be the owner who is has invested in building a good relationship with the banker…the owner that is open and transparent with them…the owner that thinks of them as a partner in their business’ success.

Everything’s people and money.  Once again, it rings true.

 

Budget or a Predetermined Profit Plan?

During the past few months, many businesses owners have been working to figure out what they expect their upcoming financial picture to look like. A lot of time is spent trying to determine expected sales levels and how much to allow for expenses. All too often they fail to quantify the specific performance metrics that are needed to meet the desired operating results…the financial return for all our hard work.

Most people call this budgeting…Revenue – Expenses = Profit.

The problem with most budgets today is that once they are prepared they are filed away and seldom used. This of course is not the fault of the budget but rather the owner of the business…or is it?

Too often, businesses allow their budget to be nothing more than a mathematical exercise based on last year’s results. Many times it then remains static for the year regardless of current performance.  This begs the question…why would any business owner use it to guide the financial direction of their business? The comparison of the current year’s results against a set of static numbers which are based on results that are no longer relevant makes no sense.

Not only are most of the budgets I have seen over the years static, they are seldom based on the specific performance metrics that the business must reach to hit the budget. The result is that the budget is based on a different set of criteria then how the business is operating.

For example, if the business is operating at 75% productivity and the budget unknowingly assumes 80%, then actual performance will never match the budget. Sadly owners may never know why.

To provide a financial map for managing their business, businesses need to adopt a “Predetermined Profit Plan” (PPP) instead of an old school budget. A PPP incorporates the mentality that profit is the key driving force in the successful operation of the business.

In developing a PPP performance metrics are the foundation of the plan. Metrics must be set for every department.  The business owner can then see the direct financial result of the performance metrics and can adjust the targets if they don’t produce the desires results. In a PPP, profit is not just what’s left over after subtracting expenses from revenue…it is the goal!!!

Sales volume is the first number we determine when developing a PPP; profit is the second number. Once the sales number and profit are determined, you can identify the necessary costs of maintaining the operations of the business and quantify the performance metrics that must be achieved in every department to hit the goal. As you can imagine this is where the real work begins…balancing performance metrics and expenses.

In order to monitor and improve performance metrics, weekly “Flash Reports” must be prepared. When monthly financial statements are finally prepared, you will already know what to expect and the results won’t be a surprise.

In comparing the PPP against the monthly financial statements, the comparison must be done on an “Apples to Apples” basis using a dynamic common point of reference…which I think is a good topic for next time.

To the Middle 60%

We all know the last few years have been rough for many business owners.

For the top 20% of small and medium size businesses (SMBs), things now seem to be going pretty well.  Your business is growing and your cash flow is strong.   People are buying your products or services.   As they say on those really cool tee shirts, Life Is Good.

For another 20%, and unfortunately I am referring to the bottom 20%, life has not been so good.  Some of you are not reading this because you are out of business.  Others are on life support.   The recession has not been kind.  Charles Darwin referred to it as survival of the fittest, and many of you have been eaten.

But for those in the middle – 60% of SMBs – you are still working hard to figure it out.  For some, cash flow is tight. For others, revenues may be flat or down.  But you keep your head up every day and continue to work hard.

But while you put on a good face, sometimes you are not sure.  You have been telling everyone things are great, or fine, or getting better. But you may not have had a good night’s sleep for a while.

So here is a message to all of you in the middle 60%.  It’s time to stop worrying and take some action.  Here are three things you should do:

1.  Wake up every day thinking about how to grow your revenue and improve your profits. You are the most valuable asset in your business.  Your time is worth hundreds or even thousands of dollars an hour.  Getting new revenue and maximizing the profitability of your operations are the keys to the success of your business.

2.  Make sure you are not spending your time on administrative tasks.  Some business owners take time out of their busy schedule to do some bookkeeping, pay some bills, or update some accounting reports.  While there may be a time and place for some of this, if it gets beyond 5% of your week, you may be headed for trouble.  Make sure you are running your business, not keeping your books.

3.  Develop a cash flow based budget for the next 12 months and update it at least every three months. A “cash flow based budget” does not stop at net income. It includes things like accounts receivable and accounts payable, inventory, WIP (work in process).  All of this impacts cash flow which is much more important to a business owner than net income.

So for the middle 60%, let’s focus on the right things.  Be the leader your business needs. Turn your “business” into a BUSINESS!

Oh, one more thing.  For those of you in the “top 20%” that I mentioned in my first few words, I hope I was right when I said Life is Good.

But then again, thinking back, in 2007 everyone thought Life was Good.

Let’s all follow these three steps to make sure we continue to move forward.

Fraud

Do you think that fraud cannot happen to your business or at one of your clients?  If you said yes to this question than consider the following facts;

• Misappropriation schemes are the most common form of fraud,
• Frauds last approximately 18 months before being detected,
• Small companies are disproportionately victimized by fraud,
• The median fraud loss for companies with under 100 employees is $150,000,
• The departments most susceptible to fraud are Accounting and  Operations,
• Most frauds are discovered by tips

Fraud is defined as personal enrichment through deliberate misuse or misapplication of the employee’s organization’s resources or assets.  Examples can range from pilferage of company supplies or manipulation of timesheets to financial statement fraud.   Asset misappropriation made up 89.8% of reported frauds.  The remaining frauds were either corruption or related to financial statements.

The above facts are based upon the 2010 Global Fraud Study prepared by the Association of Certified Fraud Examiners (ACFE).  Where possible, the facts used are US based and are extracted from the Global data.

Misappropriation Schemes

Three schemes made up the majority of the methods of fraud experienced by small business.  These schemes were billing, check tampering, and skimming.  In small organizations the functions of check writing, cash collection and payroll functions may be performed by a single individual with limited oversight from management.  While most frauds were committed over an 18 month period, check tampering, expense reimbursement, billing and payroll had a median duration of 24 months.

Effects on Small Companies

Companies with less than 100 employees experienced 30.8% of the reported frauds.  This was the largest percentage of any of the brackets reported.  The median fraud loss reported for this category was $150,000. The leading industries for fraud were banking / financial services and manufacturing.  The distributions within all other industries were very similar to each other.

Where committed

In the United States the reported frauds were committed by employees (46.2%) and managers (36.7%).  On average the employee frauds were estimated to cost the organization $50,000, while the managers were $150,000.  Owners and executives make up the balance of the reported frauds and on average cost their organizations $485,000.  Presented below is a breakdown of the departments where fraud was reported

The Inventory Trap

I recently spoke to a business owner who was in a real bind – an inventory bind. He had gotten caught in the inventory trap.

A very influential customer had called and said they were considering placing a big order. The customer asked if they would be able to handle it. The owner did the math and said yes. If he wanted to fill the order, he would need more inventory.

He immediately called his supplier. The supplier said, yes, they could produce it. To be ready for the “big order”, the business owner asked them to start. The inventory began arriving a few days later.

Then came the problem. Two weeks later the large customer said they had changed their mind.

The business owner had already received his order and, no he could not return it. He felt it would take about 12 months to sell, if he was lucky. His cost was $300,000 and he had gone into his line of credit to buy the product. He had fallen in the inventory trap.

It is an age old dilemma. Which comes first – inventory buying decisions or sales vision?

Yes, there are some who buy inventory based on what they hope they can sell. Large retailers do it all the time. But they don’t do it in a vacuum. These large retailers determine what to buy via a rigorous testing process. They buy new items in small quantities and test in 15-20 stores. What sells quickly out of the box will potentially become part of the large buys for future deliveries.

Next, they also spend a ton of money on advertising, which influences customers buying their inventory.

And THEN, if they are wrong and buy too much, they quickly mark it down to cost or below to get rid of it.

However, most businesses don’t have these resources. So, too often this becomes a lesson many learn the hard way. Many don’t learn and simply drown in a sea of product they can’t sell.

So what is the answer?
The answer is you do not buy inventory based on sales hopes and dreams. Rather, you actively sell what you have in your inventory.

Said another way, you buy inventory based on a well thought out plan. Then you aggressively sell everything you have in inventory.

This is why you need good inventory management and a solid, consistent, well managed sales process.

The worst answer is to buy inventory and then hope you can sell it. Sure there are exceptions, but ask yourself how many exceptions can you make?

Do this – run a report on how much inventory you have on hand that is over six (or even 12) months old. Compare the total cost of that inventory to your bank line of credit. The amount of stale inventory is often close to the line of credit balance. Surprise!

It is never a good business model when your bank loans you money so you can go out and buy a bunch of inventory that you never sell. This is often why your bank can’t give you more credit.

It’s also why you don’t make money in your business.

So do this. Just sell the old stuff. You might not make anything on it and you might even lose some money. But take whatever cash you can get and go out and buy some stuff you can actually sell and make money.

Remember, we aren’t running museums. We are running businesses.

Contact me at:
Brad Martyn, FocusCFO
b.martyn@focuscfo.com
614-944-5760
www.focuscfo.com

STRATEGIES TO MANAGE YOUR BUSINESS

Sometimes organizations suffer from events that cause negative consequences to their business. Some are controllable and some are not. The one’s that are most successful at managing these events have two things in common: 1) they are proactive in managing their company and, 2) they have a prospective system in place to measure key indicators of the business.

The potential list of indicators lies across the spectrum of your business. They are represented by the key functional areas, e.g., sales, operations, finance, R&D. Each business or industry has their own unique indicators in addition to these general categories.

Among many tools available to measure your company’s key indicators, one that has universal application is the Trailing 12 Month Chart. It provides you with a graphical presentation that identifies potential problems well in advance, allowing you to take action to prevent problems from becoming a negative consequence. Let’s take one example of how to utilize this effective tool tracking sales revenue.

The Trailing 12 Month Chart is a graph that is developed by using a spreadsheet to track a specific indicator, in this case sales. For this example we will track three years of sales from 2007-2010, using three years of history plus the current fiscal year.

In column A of the spreadsheet list the monthly period, starting with Jan 07 in row 1, Feb 07 in row 2 and so on down the line. Column B should show the actual sales for the period. Column C becomes a calculated figure by summing the first 12 months of sales (Jan-Dec 07) in the row for Dec 07. In effect, you have calculated the last 12 months of sales cumulatively as of Dec 07. In the Jan 08 row of column C, the formula for the last 12 months of sales becomes the sum of Feb 07 thru Jan 08. You then copy and paste this formula down the line to the most recent period in column C.

The next step is to develop a graphical presentation of the data just gathered in column C which is easily done using Excel’s graphic feature. The result is a living document that you can update each month by following the same process as described above.

More importantly, you now have a rolling total of annual sales by period that removes any seasonality when comparing results. Reports that only track sales on a monthly basis can show significant fluctuations from month-to-month and do not give an accurate picture comparatively speaking from the same period in the prior year.

The beauty of this tool is that it provides a historical trend line that can be used to proactively manage sales for the future. For example, it will show you trends when sales downturns hit your business.

You can use this information to apply creative thinking in advance such as developing incentives to generate more sales during the historical downturn periods. The goal of the Trailing 12 Month Sales Chart is to proactively manage your business so the trend line is always moving up.

Next time, we can explore additional uses of this tool and other measurements and strategies to manage your business by looking forward, not backward.

The New Normal

We’re in an expansion. No, really.

The other day, a business owner was bemoaning the current recession. I told him I hated to break the news to him, but…

Did you know that on September 20, 2010, the Business Cycle Dating Committee of the National Bureau of Economic Research officially declared the recession that began in December 2007 was officially over in June of 2009? Feel better yet?

Well, it’s true, statistically speaking, the longest recession since World War II is over. But government declarations aside, most businesses are still struggling with the ongoing conditions of high unemployment, tight cash flow, changing banking practices, government uncertainty in taxes, health care and regulation, and hesitant customers.

This expansion looks like it will be different than the last. Our economy has expanded for over sixteen years, with the exception of a short recession in 2001. During that time from 1991-2007, the economy grew at a 3.1% annual rate. Today, however, economists see considerable risk in the global economic environment. Most forecast growth of only about 1% for the foreseeable future. You often hear this referred to as “the new normal”.

So what should you do in “the new normal”? The best way to do it is to focus your business on:

“Health, then Growth”

First, health.

A healthy business generates positive cash flow from operations. There are 3 or 4 indicators of a healthy business:

· Sufficient gross margins

· Productive utilization of people and assets

· Satisfied customers

· High turnover of inventory and receivables

Businesses that were healthy going into the last recession were able to effectively weather the storm. Some even grew! A car dealer I talked to said he had a record year in 2009, just by focusing on the fundamentals and anticipating changes in customer wants and needs during the downturn.

Other businesses were forced to react to the recession by cutting people, freezing salaries, reducing training and cutting capital budgets. Owners were distracted from business development because they had to focus on just keeping the ship afloat.

If your margins are not where they should be or your cash flow is still tight, you should focus on these issues now before your competitors get a leg up on you.

Then Growth.

Once you’ve established the health of your business, it’s time to focus on growth opportunities. As slow as it may be, for many companies business is better now than it was in 2008. Opportunities are out there or may present themselves soon.

A healthy business will prepare for opportunity by:

· Investing in its sales force

· Enhancing its product or service offerings

· Marketing its business

· Training its people

It may be able to attract bank loans or other investment to buy weak competitors or complementary businesses at a discount. If you are healthy and your competitor is not, now is the time to capitalize.

Following an expansion, the next recession will inevitably come. Some think we are headed for a double-dip recession, others think the expansion will be slow but long and steady, but either way, another business slowdown will come. Don’t know when, but we must be prepared for it.

So, keep a close eye on the economy. Talk regularly with your customers, suppliers, and financial advisors about what they are seeing. Whenever the next recession hits, be prepared. Those who learned the lessons from the 2007-9 recession and have healthy cash reserves will be best positioned.

I know it’s not that simple. Trying to predict what will happen is an art not a science. And it differs by industry. But those who pay attention and take actions accordingly will be the winners. We at FocusCFO would be happy to sit down with any business owner or CEO and discuss how this may apply to your business.

Mike Jokerst

Partner, FocusCFO

M.Jokerst@FocusCFO.com

How Much Cash Does Your Business Generate?

I recently met with a business owner and I asked my standard first meeting question, “So what information do you use to run your business?” After almost ten years of asking that question to business owners, I continue to be amazed at the responses I get.

“Well, I know I have some reports. Let me see if I can find them…oh, here they are.” Hands me sealed envelope.

”Data, have we got data!” Then he hands me 30 pages of metrics and reports.

And then the infamous, “Here you go – hot off the press. Here are my tax returns – federal and state” (this is usually in September and the returns had just been filed for the prior year).

When I was growing up in the CPA world, and then as I started in the public company world, I noticed we spent a lot of time on the income statement and the balance sheet. Everyone does. That is where we all got our start. CPAs ask for them. Bankers ask for them. Business owners have been conditioned that these are the key reports they need to run their business.

So after working in many successful business environments for most of my career, what have I learned?

Those are the wrong reports.

It’s the cash flow statement that you need to successfully run your business. Then once you get it, just go to the line that reads “Cash Flow from Operations”. This is where the answers (and the questions) are found.

I have found that most business owners don’t look at their cash flow statement. Some actually don’t even have one or know how to read it. It often is not found in a standard set of financial statements and there certainly isn’t one in a tax return.

Even if there were there, business owners typically would not look at it because they usually don’t understand it. Yet, it is the key to running your business.

Not long ago I met with a potential client that was a business owner. I made reference to Cash Flow from Operations as being the most important number in a set of financial statements. The owner looked at me and told me I was dead wrong. He pointed out that in the last three years that number had never been very big so it can’t be important. (He was about 30 days from being pushed to managed assets by his bank).

Maybe if his Cash Flow from Operations had been higher, he would not have been in such bad shape.

Cash Flow from Operations tells the whole story. It starts with revenue and ends with the amount of cash that your business generates from revenue generating activities. Cash, not profit. Plus, it does not count the cash you borrowed from your bank, or that you got from your investors.  Just pure and simple, how much cash does your business generate.

Too often cash gets tied up in accounts receivable, or in inventory. Cash Flow from Operations shows you that. On occasion, when we catch up payables, we use cash. Cash Flow from Operations shows you that. Sometimes, overhead is too high or margins too low. Cash Flow from Operations shows you that.

Let’s make sure we help our clients and business owners everywhere know the truth – whether they like it or not. Cash Flow from Operations is the key measurement in any business.

And if you don’t have Cash Flow from Operations, you may not have a business for very long.

So what do you think? If you have any cash flow experiences, feel free to comment.