If we, as an industry, didn’t fully understand the importance of strong cash reserves and strong operating cash flows in the Great Recession, I think it’s a slam dunk we will in the COVID-19 crisis. There are two truths about our world and, more personally, the industry we live and work in that we will confront when we’re past this crisis.
- We truly do live in a VUCA (volatile, uncertain, complex, ambiguous) Things are changing faster. Probabilities that used to work for forecasting have changed and things have become more uncertain. It’s gotten harder to understand what we can and can’t control. One only has to look at recent events to see that leaders, based on incomplete information and old biases, can misread situations terribly and lose precious time in getting the right thing done. There are skeptics who are in denial about VUCA. I can only wonder if a lot of them haven’t lived long enough to understand the differences between the 21st century and the 1960s and 70s.
- The way we do business, in less than a year, will have changed. More people will work from home. More people will shop online and have their orders delivered to their homes. Business travel will probably decline as videoconferencing becomes the new norm. Business owners and executives will work to change their business models to reduce costs and fortify their companies against future shocks because they will surely come. There are lots of other ways that the way we do business will change. I am sure the reader can add a lot to the list.
Thinking about this prompted me to put together a few ideas worth considering as we get to the other side of this crisis.
- As an owner or executive, give some thought to setting a goal of accumulating cash on hand on your balance sheet to a level of, at least, 25.0% of your total current assets. Profit leaders have always done this. In addition, once you’ve reached that levelof reserves and, as the business grows, increase it in direct proportion to the growth in current assets on your balance sheet. Lastly, always reassess the level of volatility and uncertainty in the economy and determine if you are carrying enough reserves. If you believe there is turbulence ahead, you can always accumulate more reserves on an interim basis. Setting and staying focused on this goal is the key.
- At the end of every month and at year end, look at your income statement. Take your net income before taxes and add your charges for depreciation back to it. Next, subtract the principle on debt for the month or for the year at year end. (Profit before taxes plus depreciation minus principle on debt.) This number is called “free cash flow.” The dollars ultimately go on your balance sheet after taxes at year end. You’ll need to continue looking at traditional profit calculations and statements because they are how your CPA or CFO determines your tax bill. PIA profit leaders average around 10.0% pre-tax profit with year-to-year variation. Generally, there is a fairly close relationship between traditional profit and free cash flow in my experience so I would, if I were you, use the PIA ratio studies as a reference to peg your free cash flow results.
We’ll be discussing the importance of your break-even point next. There are three numbers we need to calculate to derive it. They are:
Contribution is what is left over on your income statement after subtracting everything consumed in the production of jobs or orders from your sales number. This includes items like paper, ink, plates, outside services, freight, factory direct labor, and factory supplies. The items listed here are common in an offset printing company and will need to be adjusted to reflect your business if that’s not what you do. Contribution margin are the dollars left over after this calculation. We will use the percentage of contribution to sales in the calculation of break-even points.
Cash Fixed Costs or Overhead
This is the rest of your costs that are not directly chargeable to jobs. This includes things like rent, debt service, utilities, indirect labor, supervision, selling expenses, administrative (i.e., accounting and human resources), executive salaries, and a few other miscellaneous items. Remember, depreciation is not a cash event and is not included in this number. Principle on debt is a cash event and gets included in your cash fixed costs number.
This is the point where the contribution dollars in a job, month, or year have covered the overhead. To calculate a break-even point we need two numbers:
- Contribution margin as a % of sales.
- All overhead costs that are cash events. Hint: take depreciation out of the overhead and add all debt service including the principal on loans.
Next, convert the contribution % to a decimal and divide the cash overhead costs by the decimal contribution rate. For example, if your cash overhead is $100,000 per month and the contribution margin is 46.0% of sales, do the math and your break-even point is $223,000 in sales per month (rounded off).
When all ash fixed costa, including principle on debt, you start generating positive free cash flow before taxes. At year end, after taxes, you have net free cash flow which should find its way to cash on hand on the balance sheet.
Get acquainted with your break-even point. It should be obvious that to build the suggested level of cash reserves, you need to consistently, month after month, generate strong levels of free cash flow. There are four factors that challenge this effort. These are:
- Consistent strong sales
- Consistent strong contribution margins
- Consistent levels of cash fixed costs that are as low as possible
- Sales seasonality.
The metric for relating the first three factors is called the break-even point or BEP. The other factor that is not part of the calculation but is crucial to maximizing net free cash flow is the seasonality of sales.
Next let’s create a visual image of how all this works together. Here’s how:
Take the individual monthly financials from last year and:
- Calculate the contribution margin % for each month.
- Calculate the cash fixed costs for each month.
- Calculate the BEP for each month.
Next, plot a graph showing by month:
- Contribution (be sure to calculate each month’s % to sales)
- Cash fixed costs
- Free cash flow (before taxes)
- Break-even point
- Show the average BEP for the year as a line across the graph. This will show the months that had higher than average BEPs and lower than average BEPs.
This is a busy, slightly complex graph. But…what you are looking at is the impact of seasonality on your business. Pay attention to what the BEP does when sales go up or down. It may seem a little counterintuitive.
Let’s take stock of where we are so far.
- We need to build cash on hand to reach, at least, reserves that are 25% or more of total current assets.
- To achieve this, we need to raise the rate at which we generate free cash flow. We need to become a profit leader according to the PIA ratio studies and, depending on the interest rates we have on debt, generate 10% or more pre-tax free cash flow on sales. We also should avoid taking on debt to acquire assets we cannot support with sufficient sales to achieve a healthy level of ROI. If you dig into the ratio studies at a deeper level there are indications that poor investment decisions are a significant reason for the differences between profit leaders and profit laggards.
- We need to not only start questioning, but dig deeply into why the break-even point is important in our business and why month-to-month variation can be so detrimental to achieving our goals of maximizing free cash flow and, ultimately, robust cash reserves on hand.
What I’d like to do next is look at break-even points and how to think about them in our quest to help the business generate a lot more cash.
There are three main ideas that, if worked on diligently, will help to reduce the impacts of seasonal variations in sales. These are:
- Improve your contribution % to sales.
Simply put, this is improving the rate your business model converts sales dollars into contribution dollars. There are several ways to do this. New technology that automates significant parts of the way presses, folders, stitchers, etc., operate is obviously a good idea if:
- You can afford it.
- You’re willing to retrain your employees to use the technology properly and hold them accountable for doing so.
- You’re willing to measure throughput levels on a daily, weekly, etc., basis. You must publish these measurements on a press (or other machine or activity), shift, and operator basis. Give those operators goals and publish weekly their performance against those goals.
Let me give you an example of the third point. When I was running Belk Printing in Charlotte, N.C., in the late 2000s, we implemented a productivity measure in the pressroom. It was net impressions per manned hour…not just job chargeable hours, but all hours. We posted the numbers weekly by press, by shift, by crew. There was a lot of peer pressure but we saw a significant gain in overall pressroom productivity. Some of the results were:
- Throughput improvements allowed us to quit running one of our three presses;
- Contribution margins went up significantly;
- We were able to lower prices without sacrificing profit because we didn’t give up all that much of the additional contribution we gained;
- Sales grew by almost 50% in 3.5 years running one less press most of that time.
In general, improving contribution % to sales is about improving throughput per hour. This can be done by automation, reducing waste, process improvement, and the implementation of measurement systems that foster the motivation to achieve improvement oriented goals. This is an area where I think the industry understands the tools and use them well except for throughput oriented measurement and goals.
- Lower your cash fixed costs.
This is smart and it definitely helps generate more free cash flow. Many companies have long since begun this effort. Many are floundering in the effort. Hint: it will take fewer but better people to really make this work. It also takes better leadership.
A good definition of cash fixed costs or overhead as most people call them is the following question. What does it cost, other than the direct costs that produce and deliver a customer order, to make the business work?
- Do I really need all this space? Can we make it more efficient?
- Do I really deeply understand my internal processes enough to buy the software necessary to automate them and eliminate human involvement in all these transactions?
- Do I have the right talent to combine two or more jobs that truly aren’t full time?
- Is everyone in jobs they are likely to do well? How does my depth chart look and do I have a succession plan when I lose someone? Who are the most promotable people we have and are they being properly developed?
- What is the most effective “go to market” approach or strategy for us? Will effective marketing reduce the number of salespeople we need and make the ones we do have more effective?
- There are more I’m sure you can add to the list. This is not meant to be a comprehensive list but one that is suggestive of what kind of thinking is required.
Overhead costs produce little that your customers pay for. But, the functions paid for in the overhead are crucial to insuring that your customers get what they want and will pay for. Equally as important is that overhead is where the people are who will, hopefully, make the right decisions to keep the business alive and sustainable into the future show up as costs. We don’t see the benefits of these people decisions unless they show up as profit and free cash flow.
- Work to find customers whose seasonality is a bit different than your current customers.
There are two things to be done here and neither one is easy.
First, find customers whose seasonality does not match yours. In other words, their peaks tend to sync up with your valleys and vice versa. The typical commercial printer’s seasonality has always looked like most of the retail industry’s seasonal peaks and valleys. There’s a spring peak and a peak somewhere deep into the holiday season. Retail and commercial printing have historically looked like twins in terms of seasonality.
There are a lot of industries and market verticals that have different seasonality than print. The travel industry tends to peak during our weakest months. Non-profits tend to go to their donors before the spring and holiday retail seasons. People don’t normally have as much money to spend after the retail peaks. Manufacturers whose sales strategy includes event marketing and direct mail attend trade shows and conventions that don’t sync well with the retail seasonality cycle. Automobile sales are the largest component of the retail industry, even larger than grocery retailing. Are you smart enough to create and sell a “new movers” direct mail campaign? Or, creative enough to help local dealers create a customer loyalty program?
Second, take a hard look at your peaks. Ask yourself these questions:
- How many unusually large jobs do you do, especially from customers you don’t see much of the rest of the year?
- How competitively are those jobs priced?
Next, I want you to consider a few thoughts that might be considered contrary to conventional wisdom.
First, your company has an average order size. Of course, there is a range of sizes above and below your average. But, in my experience, these large orders that come in the peaks are way above the average.
Second, your average order size establishes a rhythm in your plant. People and processes work to that rhythm. Anything far enough outside of your average order size becomes disruptive. The further from the average the more disruptive they are.
Third, let’s consider the consequences of selling these unusually large orders. You’re already in one of your peaks so you’ve got plenty of business from your core customer base. The disruptive impact these large orders have starts with the number of times you break into them to run your core work. One October about 10 years ago, I saw an order sold that was 75 times the average order size. It had to be taken off every piece of equipment in the building over two dozen times to run core work. You can guess for yourself the number of extra wash-ups, make-readies, plate remakes, missed deliveries, etc. Think about the impact on workflow with all those extra pallets sitting around clogging the place up.
Fourth, what about the impact on profits and cash flow? The competitively priced large order didn’t have the normal contribution margins from the start. With the costs of all the disruptions the contribution that was in the job was eaten up. In addition, a lot of contribution in the core work was negatively impacted. Most of this was from overtime and extra temporary labor.
The net result of all this was that the profit that month was dismal when compared to the high sales number. How many of you have experienced this?
- The goal is 25.0% (or more) cash on hand as a percentage of total current assets. Think robust reserves.
- Learn to use free cash flow as one of your primary business metrics. Set a goal of 10.0% free cash flow to sales.
- Understand your contribution margin, your cash fixed costs, your break-even point and how everything varies month-to-month with your sales seasonality pattern.
- Look at your business holistically. There are three leverage points that help increase free cash flow and the accumulation of robust cash reserves. The three are:
- Improve your contribution % to sales.
- Lower your cash fixed costs.
- Find ways to level out month-to-month sales and diminish the impact of seasonality.
- Resolve to have enough cash and an effective strategy for using it the next time we have a major crisis or disruption. It will happen…it’s a VUCA world, after all.
My experience has taught me this approach works. In a VUCA world, we need to see a true holistic picture of our businesses.
What do you think?
If you are interested in exploring this further, I encourage you to leave a comment here online. You are also welcome to contact me personally at [email protected].