Commentary & Analysis
The Four Attributes of Long-Term Successful Companies: VIABILITY
By Wayne Lynn
Published: January 7, 2013
In “Survival of the Small to Mid-sized Printing Company in Today’s Chaotic Environment”, I talked about the four attributes of long-term successful companies:
In this article I will address the first attribute – Viability. In it I will talk about the keys to long-term viability and provide both some useful guidelines to gauge your present state and some thoughts on how to improve beyond where you are today. We will also offer some insight into how this attribute interlinks with the other three.
The original article stated there were five components to the viability attribute. They are:
1) Margins (as measured at 3-4 significant levels in your income statement;
2) Turnover (as measured by the amount of sales supported by your total assets;
3) Productivity (as measured at the company level in terms of sales or value added per full-time equivalent employee);
4) Leverage (the proportional relationship between debt and equity on your balance sheet);
5) Cash position (as measured by the percentage of cash on hand to your total current assets);
You can easily create a “dashboard” for your company within this framework that contains 25-30 individual indicators of your company’s viability. If you like numbers and have put in the time (or are willing to do so) to understand the underlying economics of our business, you can derive benefit from doing this. I believe most of us would be better business operators if we understood the numbers better. Just remember, as you go through the journey, you may occasionally go down a “rabbit trail” because of the fact that there are many economic variables in your business that move in the same direction together most of the time. This, in mathematical terms, means these variables are correlated with each other. Remember also, that one of the primary goals (maybe the primary goal) of making this effort is to predict future results based on present conditions in the business. Prediction is forecasting and smart forecasters tend to abide by the maxim: Correlation does not necessarily imply causation.
Correlated variables do not cause each other. There may be one or two that are the root causes of the other correlates. In the search for viability, we can really enhance our odds of success if we can find the critical few variables that do tend to cause viability or, if ignored, almost always insure the opposite.
In my experience, reinforced by years of benchmarking performance against industry leaders, there are five practices that are the “how to do it” flip side of the five components of viability mentioned above. We will discuss these but first let’s look at some rules-of-thumb characteristics of viable, profit-leading firms in this industry.
What You Find in the Financials of Viable Companies
Viable companies tend to have the following six percentages in their financial statements – five on the income statement and one on the balance sheet.
1) Direct, job chargeable costs do not exceed 55% of total net sales.
2) Cash fixed costs (overhead) do not exceed 30% of total net sales.
3) Operating cash flow (EBITDA) is equal to or greater than 15% of sales. EBITDA (for the many of you who don’t use the term everyday) is Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s what’s left after all cash costs needed to operate the business have been paid, leaving you with the money you will service your debt and pay taxes with.
4) Free cash flow (EBITDA minus interest and principle on debt) is around 9% of total net sales. The converse of this is that the amount of debt you are taking on at any one point in time should not require you to shoulder debt service costs in excess of 5-7% of total net sales.
5) Total payroll costs (including hourly wages, overtime, salaries, commissions, bonuses, payroll taxes, and benefits) do not exceed 33-35% of total net sales.
6) Cash on hand (in your checking accounts) should exceed 20% of total current assets which also include raw material inventories, work-in-process inventories, and accounts receivable. Cash, not managed well, tends to get hung up in excessive inventories, excessive billing lag, and slow moving receivables. This, obviously, puts strain on your working capital and for a struggling company in this environment of shrinking print demand can be the single most important factor between solvency and insolvency.
Let me mention right away that I am using averages here. Averages, being statistical in nature, are subject to ranges in variation. It is important to remember that. These percentages are guidelines. However, you seek balance in managing them. If you allow all of them to vary to the wrong side at once you are setting yourself up for disappointment. If you can’t fix that situation once you find yourself there it can mean long-term failure.
Business models can have unique features that violate some of these “rules of thumb” but create outstanding results anyway. It’s better to understand the reasons why than to blindly plunge ahead. The empirical evidence in this industry is too strong to push your luck without careful consideration. Also, it is worth noting that different size groupings of companies in the industry show variation around these averages but tend to move to them as a mean. For more precision, consult the PIA Ratio Studies.
The “How to” Practices That Drive Viability
Now let’s turn to the 5 “how to do it” practices mentioned earlier. They fall into the following broad categories;
- Managing headcount
- The “make versus buy” decision
- Purchasing philosophy and practices
- Pricing philosophy and practices
- Cash conservation disciplines
These are the root causes of the percentages that manifest themselves in the financial statements of the most viable firms in the industry – the profit leaders. They are also intimately intertwined in the other 3 fundamental characteristics of relevance, adaptiveness, and durability. We will expose those relationships in future articles.
Headcount is a major factor in job chargeable costs, cash fixed costs, and total payroll costs. It is the major impact on at least half of the six percentages discussed earlier. If there is one single factor that plagues marginal companies in the industry more than any other it is excessive headcount. The truth is that there aren’t many reasons for this. Extra headcount tends to come from one of four causes:
- Poorly designed systems that were never implemented well
- Lack of cross-training
- Trying to do too much in house
- Procrastinating in dealing with current reality
These are exceedingly difficult to reverse. The systems issue manifests itself in the overhead areas of customer service, planning, estimating, accounting, and purchasing. It can even be a problem that decreases the productivity and time management of the sales department. People, not using the capabilities of their systems, usually have too many transactions required to accomplish their jobs. This can be fixed but it takes determined leadership starting at the very top of the company. You paid for it, get your money out of it. The systems issue also manifests itself in the fringe areas of manufacturing: shipping, receiving, and some parts of pre-press. It requires the same process to fix it.
Lack of cross-training and trying to do too much in house are related. They both stem from mistakes in the “make versus buy” decisions made some time in the past. In reality, these decisions may have been good ones at the time but, with changing mix and shrinking demand, they aren’t good decisions today.
The headcount issue gets created when the decision to buy equipment or software is made. These decisions are justified by the idea that you can make more money doing something in-house instead of buying it outside. These are very tricky decisions. Many times assumptions regarding the utilization of these new assets are too aggressive. When the expected volume does not materialize you have damaged the overall balance between revenue and costs in the business. In addition, you probably took on more debt. The really insidious impact, however, is the way these decisions get implemented. Invariably, I have seen knee jerk reactions that conclude with the decision to hire someone new to run the equipment. Giving no consideration to cross-training current employees puts you in the situation where most of the plausible outcomes will be negative to your financial health.
If the initial volume assumptions were wrong, a headcount issue is automatic. If they were OK initially, but are now a problem due to declining volume or shifting mix, you have a headcount issue. The problem can be resolved in one of two ways:
1) Reverse the make or buy decision, sell the equipment, and eliminate the headcount; or,
2) Cross-train your employees and eliminate the weak links in the headcount. You can then keep the asset if there is not significant debt still attached to it. If there is, you need to look at the current volume on the equipment and determine if the contribution levels are high enough to cover all direct costs associated with the asset plus the debt service. If you’re leaking margins after this analysis, find a way to get rid of the asset and the debt.
Make versus Buy
Continuing the conversation further into the make versus buy decision itself, let’s talk about the basics of the decision. Profit leaders tend to have a somewhat smaller asset base than profit laggards. They also tend to buy more services outside. This is an indication that the decision to invest in new assets to bring work in house is made with more challenging criteria. In simple terms, the new equipment must attract enough volume to generate sufficient contribution margin to be in line with the overall margins of the business in total. A key factor in the amount of contribution generated is whether or not additional direct labor will need to be hired. There is usually enough slack in the existing employee base where cross-training can negate the need for new hires…at least until the needed and anticipated volume does materialize. Take great care in making these decisions. They are not easy to unmake.
The last headcount issue is procrastination. We have been in an economic slump in the US for five years. The printing industry is shrinking and shifting from offset as the dominant process to digital technologies in the dominant position. Page counts, order sizes, and all manner of other indicators have relentlessly moved in a negative direction for years. The good old days are not coming back. Not dealing with the residual headcount issues that you’ve avoided for the past 5 years only hastens the day when you are no longer viable at all.
Many, I would say most, printing companies approach the purchasing task in one of two ways;
1) Get 2-3 bids on everything you buy and let the low price win;
2) Pick a couple or three favored suppliers and spread your purchases around to make them work for the business and insure you always have a backup.
There is nothing intrinsically wrong with either of these or a combination of both. The problem stems from the fact that the majority of your direct, job chargeable costs are purchased materials, services, and supplies. When you compare profit leaders and laggards with each other in the same size groupings there are considerable differences in the percentages. This typically stems from the approach to purchasing. It has nothing to do with scale or the purchasing power flowing from scale because we’re comparing companies in the same size ranges.
Getting the best value for your money in the purchasing area requires some work. It is work that is generically different from the daily routine of asking for bids, getting the quotes back, picking the lowest price, and issuing a purchase order. It requires you to get creative, aggressive, and negotiate hard. Done right, you will likely end up with fewer suppliers, better pricing, and lower transaction costs. You’ll also have business partners with a stake in your success.
The best practice I’ve used in the past few years involves going to your supplier community with the entire spectrum of what you’re buying for direct, job chargeable items. Offer a primary supply position (65-75%) and secondary position (25-35%). Ask everyone to put their best offer on the table for everything they can sell you. It may take a couple of rounds of refining bids and negotiating until you have the best possible scenario. Be ethical; don’t share information with some bidders and not the rest. It needs to be a level playing field. Commit to at least a year to the winners. They must make the same commitment to you. Longer is better but you need to take your program back to market periodically to keep everyone honest. By the way, be sure to put in writing in plain language what the rules are for raising or lowering pricing. There are legitimate issues that make it the fair thing to do at times. But, it needs to go both ways.
There are several benefits flowing from this approach. The daily bid process is gone. It shouldn’t be necessary because you now have “everyday low prices”. Most of the transactions with the suppliers can be automated and done over the internet. Delivery arrangements can be made on a more “just-in-time” basis keeping inventory off your floor and off your balance sheet. This will free up cash and move it back into your checking account within a couple of working capital turns. The supplier can get more involved in your internal processes and help you improve them. It’s in their best interest to do so. There is much less opportunity to point fingers toward another supplier in this approach and you will need their help in overcoming internal resistance to the changes you will make in what you’re buying. Remember, for you to get to the lowest overall cost to operate, everything in the system needs to work together. Pressrooms and binderies, left to their own devices, will gravitate toward products that are more tolerant of process variation. By definition, these are usually more expensive. This takes work to make it work and you will need good technical help from the supplier.
I have one last note on purchasing practice. There are fewer opportunities in the cash fixed cost area than in manufacturing but there are some important ones nevertheless. One in particular is the cost of health care. Don’t just roll over and accept the annual increases that the insurance company wants. Find a good broker and get him to provide you several quotes with different plan options. Develop a strategy of where you want to go with these benefits. Health care costs are rising for several reasons but a big one is that we are not as healthy as we could be. There are plan designs available out there that can help you encourage your employees to take better care of themselves and, longer term, help to keep costs under control. It’s something to think about.
Now, let’s turn to one of my favorite subjects: pricing. Consider these points of view:
- The pricing decision is the most important daily decision made in your business. You need to closely monitor what’s going on.
- There should only be one markup or markdown. I have never understood the nonsense of marking up materials by some percentage, marking up outside services by another, and then adding the fully burdened labor rate calculation from your estimating system only to discount the total by 5-20% to meet the competition. A year later, how do you find the “line in the sand” that represents that price level?
- Tweaking speeds and waste assumptions is delusional. Your standards are good or they’re not. If they’re not; fix them. Actual plant performance will vary around an average that should be reflected in your standards. Expecting above average performance on specific jobs or accounts is not logical and is akin to betting against the house in Las Vegas.
- The bottom line in pricing is that the level you quote will largely determine the contribution dollars left over after direct, job chargeable costs are paid for. The cumulative total of all contribution dollars from all jobs will either cover your cash fixed costs and debt service or you will lose money that month. This is the reason pricing is critical. Pay attention to it!
- All customers are not created equal. Two-thirds of your entire list of active customers generate so little volume in small orders that, when you consider the impact of the transaction costs required to enter, produce, deliver, and bill them, you need higher prices to make them profitable at all. Most of these orders are not shopped competitively anyway. Use them as a pricing opportunity.
- Pricing can be improved over time. It takes a strategic approach to pull it off.
- Rank order your entire customer list for this year in order of descending volume. Go to the customer who is the last one in the top 20% of the list. Add up the combined revenues of every customer on the top 20% list. The total will be around 80% of your company’s total sales. It’s the old 20/80 rule and I see it everywhere. You may have an even higher concentration of revenues in this group. If you do, there may be cause for concern and you should think about a strategy to broaden the customer base. The old saying about too many eggs in one basket is a real risk in the business world of today. Finally, each customer in this group should have a well thought out pricing and growth strategy developed on an annual basis.
The upshot of all this is that deliberate, disciplined attention to pricing can make a 3-5% difference in your bottom line. After you’ve right-sized headcount and lowered your cost to operate through more effective purchasing, you can usually get the EBITDA levels that profit leaders attain with a little work on the pricing side of the business. For the moment, I’ll rest on that. There is much more that can be said about the theory and strategy of pricing and the management of the function itself but that’s an entire article by itself.
Cash conservation disciplines are pretty straight forward. They do, however, require the development of skill and tenacity on the financial side of your business. The goal is to get and hang on to a healthy level of cash in your checking accounts.
Everything we’ve discussed so far contributes to this effort by putting more cash on the bottom line. Better purchasing approaches as discussed earlier will help move cash tied up in inventories back into cash on hand. Dealing firmly and emphatically with billing lag issues takes cash tied up in WIP and puts it back into cash on hand. Monitoring accounts receivables and aggressively managing credit terms will complete the cycle. Don’t be afraid to turn your oldest receivables over to a collection agency. It’s your money and you’re not in the lending business.
The final note on cash conservation may be the most important. It is certainly the most personal. It takes discipline to maintain the level of cash reserves required in this chaotic economic and political environment. Many of us can’t resist the temptation to go buy that extra piece of equipment you want with any “spare” cash you may think is just lying around. (Remember the discussion about mistakes in the make or buy decision.) Too many of us can’t resist the temptation to write ourselves a check so we can buy that new car we want. You own the business; those decisions are the fruits of your labor. Just do yourself a favor. Make sure what you take out still leaves adequate cash reserves equal to 20% or more of your current assets. It’s a discipline you’ll never regret.
- It is important to measure and monitor key viability indicators in your business.
- Looking at their behavior over time gives you the ability, notwithstanding the potential for unexpected surprises, to predict future performance. Being able to take your mind off the things that are working is crucial to the mental health of the CEO/business owner. It also helps to keep you focused on the few variables in the business where your time and attention will really make a difference.
- Commit to looking at, on a monthly basis, the six percentages you usually find in the financial statements of profit leaders.
- Look honestly and hard at the 5 “How to” practices to help you drive toward improved viability.
- Commit to being viable. If you’re not there, get there! If you are there, commit to the disciplines needed to stay there.
- For a long time it was possible to start and own a printing business and support the lifestyle you wanted. In the US this is a large part of the American dream. Things have changed and they’re going to change some more because of the dynamic nature of an industry re-inventing itself. If you’re going to survive some personal “belt tightening” is possibly in order. I’m just saying…
Where to Next?
A for-profit business is an organization that is, first and foremost, an economic one. The disciplines that create viability are at the core of its very existence. That has been the focus of this article.
Moving on, we know that a major piece of viability is revenue. To create sufficient revenues, a business must create and sell something of value in large enough volumes to a customer base that will insure the prospects for viability and long-term, continued success. The creation of this value is the fundamental attribute called relevance. Creating relevance is the core of strategy and your business model. It is one of a very short list of things a CEO cannot delegate.
We will come to that a couple of articles down the road. First, however, we need to address the attribute called durable. This is where the culture, values, attitudes, and behavioral norms are formed that insure the disciplines needed for executing consistent viability and spot-on implementation of the strategy that yields relevance. Then, we’ll turn to the adaptive attribute for a look at some skills your company needs in this dynamic environment, many of which are used the creation of both relevance and viability.