You’ve no doubt heard about today’s supply chain problems and the impact they are having on raw material availability (lower) and costs (higher). Finding and retaining people is a challenge, too.
With that in mind, here are several financial best practices that are critical to navigating through these difficulties.
React quickly.
That means closing the books fast, so the impact on profits and profit margins is clear early on. The same goes for weekly and daily sales reporting that tracks profit margins by customer or product. I have written before about
how to shorten the closing cycle, but the most common reason for delays is a lack of focus and priority.
Review the income statement for cost increases, particularly those that are unexpected. It helps to look at a series of the last 12 months for perspective. Also, look at the same time series on a per unit basis. Don’t ignore trends in the balance sheet either.
What can happen when you take too long to close the books and review the numbers? One manufacturing client of mine has struggled to do this on a timely basis. At one point, it was running three months behind. The company thought it had raised prices enough to cover cost increases and then some. Three months too late, the company found it had not even recovered the cost increase, let alone increased its margins.
Perform a “look ahead” exercise.
The essence of a
look ahead exercise is to project financial statements for a year or two.
The purpose is to step back, take an objective look at upcoming trends, and do your best to understand what they mean financially for your company.
Run a few scenarios with cost increases, price increases, and reduced volume from labor or raw material constraints. Project the balance sheet and cash flow, not just the income statement. It’s possible that your business can hold off on price increases or headcount reductions — but project, don’t just guess. Otherwise, your business might run out of cash.
For example, one of my clients, an IT consulting firm, had grown rapidly during pre-Covid times. The firm had shifted its customer base over the years from early-stage start-ups to Fortune 500 clients. Startups pay retainers; Fortune 500 companies pay in 90 days (if you are lucky). My client was well aware of the change in terms but didn’t work through the financial impact until it was out of cash.
Understand product or service cost.
Revisit product costs frequently and factor in current and projected increases. Also, if volume is down or likely to be down for an extended period, per unit fixed costs will go up. Update any systems that track customer or product gross margins with these new costs. When margins are down, these types of tracking system are helpful in figuring out whose/which prices to increase.
If your business lacks a system for tracking gross margins as described above, look at product cost by customer and product, and drop in current pricing to see how things shake out. Remember, if volume will be lower, fixed unit costs will be higher.
Re-evaluate what the key constraints of your business are.
The key is to identify the
critical constraints that create opportunity cost
— the cost of what is foregone
when a different action is taken
. So, if a raw material is limited and there is not enough to service all orders that require it, the opportunity cost is the lost gross margin from the most profitable customer whose order was canceled or curtailed. In deciding who to service under these conditions, understand that running the business for that large “Important” customer that is able to demand lower prices, will have a bigger negative impact than servicing the higher priced customer. Think twice about whom you want to please.
Also, dig deeper on what exactly are the true constraints. So, if the constraint is labor, product made on one machine/process may have a higher throughput (pieces or parts per hour) than product made on a different machine/process. Now, the measure should be gross profit per equipment hour.
For example, one of my manufacturing clients staffed one-third of its factory labor force from a prison work release program. When Covid arrived, the prison instituted a lock down and labor was a constraint. The company made sure to run a product line that was not only more profitable on a per unit basis, but whose equipment ran faster, so the profit per labor hour was much higher.
A few tips…
Keep an eye on your balance sheet and cash flow. Price increases boost the amount of money tied up in accounts receivables. Rising costs increases the amount of money tied up in inventory and that is before increasing inventory levels to counter the supply constraints. This is all cash the business doesn’t have as employees always, and suppliers usually, are paid before the customer pays your business.
Examine fixed price contracts. Make sure to model those in the look ahead projections. Reread these agreements to see how you can break them and, if you do, what the associated cost would be. If there is a labor shortage, perhaps those contracts are the ones that are shorted. Perhaps you have leverage and can negotiate a lower cost of exiting those contracts.
Examine pricing and trade pricing policies. When I worked for Kraft Foods many years ago, the company let the trade buy in a 60-day supply if there was a price increase and price-protected the inventory of grocers if there was a price decline. Back then, Kraft owned the Parquet margarine brand which was pretty much a commodity priced at a slight premium over generic margarine. The price protection policy helped the truly premium brands, but always killed the Parquet brand because soybean oil prices were volatile and that was 95% of cost. If you have a similar pricing policy, take that into account in your look ahead projections. More important, consider changing or restricting such a policy.
If your company doesn’t have a good customer / product profitability tracking system, now is the time to put one in. Having to calculate one-off product / customer profitability in mass is time consuming and often not practical.
Find a way to earn your
company’s cost of capital
. The important thing is to look at your return on assets — profits divided by net working capital (current assets less current liabilities) plus fixed assets. If that is less than your cost of capital (
average cost of debt and equity), then in the long term, your business is digging a hole; it won’t be able to keep up with needed capital investment and so forth.
Final Thoughts
The material and labor shortage are likely to stay with us for some time. Get in front. Now. Keep close tabs on where your company is financially. That is the fastest way to see if your company’s response is really working.
Overall, dig in deep to understand product cost and customer profitability, so that you can understand the true constraints that come from raw material and labor shortages.
