Few people maintain their ideal weight for very long. In the West, we are predisposed to being overweight and in many third world countries malnutrition is the more immediate concern. But either way, the effect on health can be serious; and it’s the same for businesses.
If a business becomes overweight or obese with bloated overheads, its processes tend to become over complicated, its organisation bureaucratic, its decision making convoluted and its focus introverted. Internal politics and posturing also tend to take precedence over customer service and operational excellence. As a result, profits are not only depressed by the cost of the excess fat but also by the health problems that the excess fat creates.
Generally speaking, it is larger businesses that tend to suffer from this affliction and, of course, it is at epidemic proportions within local authorities and the public sector. Smaller businesses are less susceptible but by no means immune.
At the other extreme, when businesses become seriously underweight, their overheads may be very low but their general health is poor, as their vital processes and controls are undermined by the lack of resources. This often occurs because necessary investment is treated as unnecessary expenditure and is perhaps the equivalent of anorexia rather than famine.
It is smaller and more isolated businesses that tend to show these characteristics; although larger ones sometimes do as well.
Against this background, if we’re faced with a business that’s underperforming or losing money, how do we know whether it needs to slim down or build up its infrastructure?
The simple way is to benchmark against a similar type of business that is optimising its performance. The table below shows simplified P&Ls for three fictitious businesses, within a particular industry.
Company A is considered to be optimising its position; so each of the others can be benchmarked against it.
The percentage columns show each line of the P&L for each company as a percentage of that company’s sales. So for example, Company A’s gross profit of £925,000 is 37% of its sales of £2,500,000.
The key comparisons are, therefore, the percentage columns.
If we compare Company B with Company A, we see that: –
- Material costs are running at 42% of sales compared with A’s 40%
- Direct labour is running at 22% compared with 20%
- Transport is 4% compared with A’s 3%.
In total, B’s direct costs are 68% compared with A’s 63%, which means that B is either selling at significantly lower prices than A or is operationally less efficient. It could of course be a combination of both.
If we now look at overheads, we see that B’s are 36% of sales compared with A’s 25%, B’s salaries and indirect wages are significantly higher (5 percentage points) but its other overheads are also higher.
Company B has bloated overheads, which, on their own, have led to a small loss. But the loss has been increased by the lower percentage gross profit. So not only is the fat adding unnecessary cost, it is also undermining the performance of the business.
If we now look at Company C, we can see that the gross profit is only 14% of sales, which is substantially less than Company A’s 37%. Material, direct labour and transport costs are all running at much higher rates than A’s. Whilst C may well be selling at lower prices than A, this is unlikely to account for such a large difference in gross profit. Poor operational performance will almost certainly be a key factor.
If we now compare the overheads of the two businesses, Company C’s are running at 15% of sales compared with A’s 25%; and they are lower across all of the cost centres, but particularly staffing. So C has saved 10 percentage points compared with A; but the lack of control, operationally, has meant that its direct costs have increased by 23 percentage points. It is, therefore, 13 percentage points adrift of A.
Here we have the classic anorexic business. Presupposing there ever was any, the fat has long been cut out and the lack of sustenance has eaten in to the muscle.
The turnaround strategy for Companies B and C will be entirely different. Company B will require a substantial overhead reduction and the introduction of more efficient process and controls. Company C will require investment in resources to give it the capability of operating efficiently and effectively; and this will mean that overheads will increase.
The examples I have shown are both fictitious and extreme in order to demonstrate a principle. In real life it won’t necessarily be that simple; and because of that, businesses often apply the wrong strategy. In particular they cut overheads to compensate for low margins rather than introduce appropriate resources to address the margin problem. In many ways, cutting overheads is the easy option; and in some cases it is the right one; but not always.
For many small and medium sized businesses benchmarking presents some difficulties because they don’t have reliable figures for their competitors. However, most industries have expert consultants, within them, who know what the ideal P&L structure should look like. I have that expertise for the industries, in which I have specialised; so when I review management data from businesses, within those industries, I can identify the key issues very quickly and can advise whether the business needs to be slimmed down or strengthened. And whilst I couldn’t do that for businesses, within industries outside my experience, there will be others who can.
In view of the risk of getting it wrong, it is always advisable to bring in expert opinion before embarking on a turnaround strategy, even if all it does is confirm that the basic strategy is right. The costs of this tend to be comparatively small; the costs of getting it wrong can be enormous. There are no prizes for being a business anorexic.