Companies need a frame of reference to plan and guide their businesses, just like any other operation. This article will suggest some benchmarks you can plan into your business.
Whether you need to drive a car, a boat or a business from A to B, you need:
- a means of choosing and identifying the destination
- a means of planning and mapping the best route
- a means of "homing" to plan during the course of the journey
- a means of altering the plan in the light of obstacles or difficulties that may be encountered unexpectedly along the way.
The destination
Strong businesses are characterised by a low breakeven point, weak and vulnerable businesses by a high breakeven point. The strength or vulnerability of a business can be calculated on a scale of breakeven points:
- Above 90% = suicidal
- From 80% to 90% = vulnerable
- From 70% to 80% = strong
- Less than 70% = exceptionally strong.
Really well run companies operate as low as 50%. Fundamentally weak operations sometimes have a breakeven point well above 100%. Even at full capacity they lose money. The first rule, therefore, is to ensure that your business is structured to be able to make money at well below full capacity.
A typical example is a food shop – a delicatessen or a supermarket – where the main business is done late in the week and has to compensate for poor sales from Monday to Thursday.
Another example is a personal business, where adequate time has to be allowed for marketing, administration and so on – say, three days a week, leaving only two for fee-earning work (maximum 40% capacity).
Some of the most successful businesses in the UK started in a "warm garage". In the case of Oxford Instruments, which makes super-conducting magnets for body scanners, it was a garden shed.
Calculating the breakeven point
Breakeven consists of two components:
- fixed costs or overheads (costs that don't change much regardless of level of output – for example, salaries and rates)
divided by:
- gross margin (sales value less costs that are directly related to output: materials, labour, dispatch, freight and so on).
The strategy of all companies is to get breakeven down and, having got it down, to keep it down. As per the scale mentioned earlier, "down" means below 80%.
The "warm garage" syndrome necessitates operating at a minimum of overheads and maximising margins.
Margin, in turn, depends on:
- maximising sales prices, and
- minimising direct costs – the direct material and labour content of sales.
The latter is usually achieved by minimising the time taken to produce the product or service. This applies particularly to professional firms.
A powerful measure of direct costs is found by dividing gross margin by time taken to produce the product or service: value added per hour. The value added per hour for each individual job is then compared with the average overhead cost of running the business, found by dividing the weekly or monthly overhead by weekly or monthly total "productive" hours worked (i.e. hours devoted solely to fee-earning/income-generating work).
Getting cash flow right
Besides profitability, the other main consideration is cash flow. In the main, to get the cash flow right you need to do the following.
- Organise work so that it can be invoiced as quickly as possible. Invoices should go out daily, not weekly or monthly. One day's sales amounts to £300 funding need for a £100,000 turnover company, £3,000 for £1 million, £30,000 for £10 million. Just ten days' delay results in the first needing an extra £3,000 to fund the business; the second £30,000; the third £300,000!
- Then, having invoiced as quickly as possible, get paid as quickly as possible. Here, terms of trade become important. "Net monthly" means that anything invoiced in January does not become due for payment until the end of February at the earliest, whereas "30 days from date of invoice" (another reason for invoicing promptly) means that something invoiced on 14 January becomes due for payment on 14 February – two weeks earlier on average.
Other possibilities include:
- trying to get down-payment with order; advance payments; progress payments; accelerated settlement at the end of the contract
- factoring (which involves transfer of your sales ledger to the factor) or invoice discounting (the preferable alternative, where you retain control).
On the stock and work-in-progress side:
- Minimise stockholding (raw material, work-in-progress, finished goods) and, for a fee-earning business, such as a law firm, invoice work as soon as possible to keep work-in-progress down.
- Again, sometimes stock finance is available, either from the customer (e.g. free-issue material) or a bank.
On the supplier side, as a general rule:
- It is bad practice to delay payment. It earns too much ill will and resentment. (How would you feel if you were not paid, as expected, at the end of the month? It is no different for a supplier.) However, it is sometimes possible to take suppliers into your confidence and get extended terms from them.
On the fixed asset side (plant, machinery and buildings):
- Minimise – another aspect of the "warm garage" syndrome. Companies frequently spend too much on fixed assets. The test is whether the consequent improvement in productivity (i.e. gross margin) outweighs the increased overhead cost (depreciation, interest, repayments, etc.). In other words, does the breakeven end up lower or higher? If the latter, don't do it.
On the funding side:
- Structure the business at the outset to ensure that its equity base (share capital and reserves) supports at least half its total funding needs.
- Thereafter, ensure that growth in retained profits is fast enough to fund at least half its growing funding needs.
Any company that plans the above guidelines and benchmarks into its business – and makes them happen – will always succeed, particularly when coming up against those that don't.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
