Most businesses become inefficient over time but don’t realise, meaning most can be improved. However, the challenge for business owners and CEOs is to work out where their business is underperforming, that is find the cause of underperformance. A great place to start is by taking a diagnostic approach. A big issue for underperforming businesses is that they can fall in the trap of treating the ‘symptom’ instead of the cause. To diagnose the causes of underperformance, it’s best to bucket them into 2 areas; External and Internal causes.
External Causes
Changes in Market Demand/Disruption. While the symptoms may include declining sales, the real cause may actually be that the product or service is no longer relevant to meet the customers’ needs. A business that monitors market trends and regularly seeks customer feedback is better equipped to innovate and change their product/service. Kodak comes to mind as a business that didn’t adapt to changes in market demand and yet they invented digital photography.
Competition. Simple supply and demand dictates that as competitors come into a market, market share of incumbent’s decline. If a price war ensures then not only can volume decrease but margin squeeze will also eventuate. Again, a business that keeps close to their customers can also gain feedback on potential competition.
Adverse Movements in the Prices of Supply. As the price of inputs increase, gross margin shrinks if there is no way to pass on those costs. This can be a huge issue for any business faced with a surprise rise in the cost of inputs. How does a business respond? Look for alternate suppliers or alternate inputs. If this is not possible then can terms be renegotiated or prices ‘locked in’? Can price increases be passed on or partially passed on to clients? While price inputs generally increase, it’s the surprise element that often causes most damage. A business that better estimates these price rises is more prepared to manage them when they do hit.
Economic Conditions. This element is self-explanatory. Economic conditions have a direct impact on business demand. Like estimating adverse price movements, those businesses that recognise the economic cycle and adapt their business accordingly are better placed to survive and in some instances, prosper.
Changes to Legislation/Regulation. Industries that are reliant on legislation, such as businesses focused on compliance management (e.g. fire safety inspection & testing, food & beverage safety inspection etc.) can also be disrupted due to changes in legislation. So too are other industries that find themselves affected by changes to legislation (think of the recent changes to the Greyhound Racing industry in NSW).
Internal Causes
Poor Management. Usually means there is poor or unstructured decision making, which usually leads to poor financial outcomes. A business that operates with poor management may find in due course they have no one to manage. High staff turnover not only impacts on workplace morale but also ensures lost productivity (time to train new staff).
Inadequate Financial Control. Any business that does not have tight financial management, will find that it becomes susceptible to unnecessary spending. One area that often creeps in is ‘discretionary spending’. While it may seem appropriate to give employees the benefit of making decisions on the go in regards to business purchases, unchecked, this can lead to abuse. Additionally, lack of controls can also lead to fraud. Look for ways to slow down or eliminate how the business spends money.
Poor Working Capital Management. This includes having poor processes around cash and bank accounts, poor accounts receivable management and poor inventory management. The aim is not just to generate sales but also to collect the ‘cash’. If accounts receivable are allowed to get out of control, it extends the ‘cash cycle’ which impacts on a business’s ability to grow. Equally poor inventory management means inventory can become slow and/or obsolete leading to waste. Look for ways to reduce accounts receivable days as well as reducing excess inventory.
High (Excessive) Overhead. Most businesses don’t start out by wanting to have high overhead, yet often that’s where they end up. It usually happens because no one is monitoring overheads and overheads grow like ‘barnacles on a boat’. There needs to be vigilance around overheads e.g. rent, outgoings (water, electricity), cleaning, administration salaries, insurance, license fees, professional fees, depreciation etc. One of the biggest ‘killers’ is rent and typically most businesses overestimate the amount of space they require. Always ask: Do we need this space? What will we do if we don’t use all of it? Who else can we rent it to?
Lack of Sales & Marketing Effort or Ineffective Spend. Advertising and marketing spend can be a bottomless pit. How do we know if the advertising and marketing is working? Many businesses ‘throw’ a lot of money to this area but have no way of knowing how effective it is, whether the advertising is in the right place or at the right time. Developing a robust monitoring process for sales and marketing spend will prevent waste and help to grow sales.
Overtrading. Many businesses focus on generating sales, but what’s the point of sales unless 1) you get paid for it, i.e. collect the cash and 2) they are profitable. Many businesses have customers that are not profitable and provide products/services that are also not profitable. In a turnaround, a business needs to come back to their ‘profitable core’, that is culling unprofitable customers as well as unprofitable products/services. How many businesses regularly review the profitability of their customers and products?
Big Projects and/or Acquisitions. As well as taking up a lot of management time and focus, this element also ties up a lot of capital. If debt is used then this could be considered the cause of decline, however the real cause is not the debt but rather what the debt is being used for. Sometimes stopping the project, even if the cost can’t be recovered, is the best course of action – as it stops the cash ‘bleed’.
Financial Policy. A business’s financial policy has a significant impact on its viability. The financial policy covers things such as: gearing; the amount of investment in PP&E, dividend payout ratio; setting an appropriate level of liquidity; setting the right days for accounts receivable, accounts payable and inventory. It’s important to strike the right balance between being too conservative, i.e. too much liquidity, and being overly aggressive. That said, it would be very rare for a business to go bust for being too conservative.
Organisational Inertia & Confusion. This has to do with having an unclear organisational structure, where there may also be a lack of clearly defined accountability or inappropriate / non-existent management processes. Again, this links back to poor management, however extends to all staff. Often there will also be a lack of alignment across the team in terms of Vision, Values and Mission. Significant value can be destroyed when a business does not have the right people in the ‘right seats’.
By understanding these causes of underperformance, both external and internal, a business can assess if these elements are impacting on their operations. Rarely is there just one cause of underperformance, but a number working in tandem. The next step is to further diagnose the specific causes of decline in these areas so that a ‘treatment’ can be prescribed.
We use our Profit Improvement Program as part of our Stage 3 – Maximise Value to help identify causes of underperformance and return the business to optimal profitability.
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