Understanding your break even point.

Understanding your break even point.

Dec 20, 2017 | Governance, Management, Small business

 

Understanding the break even point in a business is a crucial but often overlooked piece of the financial puzzle.

It is particularly important in a manufacturing business where there are both overheads  to just keep the doors open, and the marginal costs of production.

In order to make informed and sensible cost and pricing decisions, and effectively manage the business, you need to understand both.

Marginal cost

This is the cost of making and selling another widget. The materials consumed, packaging, and direct labour necessary. The difference between your sales price of a widget and the marginal cost of that widget is usually referred to as the ‘Gross margin’

For example, if a widget costs .80 cents to manufacture, (materials + packaging + direct labour) and you sell it for $2.00, the gross margin is $1.20/unit.

Fixed costs.

These are the costs necessary to keep the business going, and not tied to the cost of production. Rent, insurance, staff labour costs, marketing and sales expenses, travel, and many others. These costs keep on coming irrespective of sales.

Let’s assume your business has fixed costs of $600,000/year, it is a small business, so you as the owner pay yourself a modest wage, there is one sales person,  an office manager, rent and insurance, as well as the general costs of running a business. In the factory there are three people, a factory manager, and 2 people who work on the production line. The factory manager would normally be included in overheads, but if he works on the line part time, then a portion of his salary would reasonably be included in the costs of production.

There are always questions about where a cost should be allocated, marginal cost or fixed cost, For example, sales commissions would usually be considered a marginal cost, but sales salaries would be considered a fixed cost. Similarly with freight costs, the cost of keeping trucks on the road would be considered a fixed cost, but the cost of an outsourced courier service would be a marginal cost, as without a sale, it will not be incurred. The key is to be consistent in the treatment of costs.

Break even is the point at which all costs are covered, but there is no profit.

How to calculate the break even.

The formula is fixed costs divided by the unit gross margin.

In our case above,  the break even point would be $600,000/1.20 = 500,000 units.

In a situation where there are several different widgets, with different selling processes and differing costs of production, the calculation can be done either by taking averages, of both the sales revenue and costs of production based on average sales mix, or it can be done separately, for each of the products and added together.

In any event, understanding  the structure of your break even will assist enormously in making sensible pricing and cost management decisions. It will also make the choices that  impact future cash flows, such where to concentrate your limited sales and marketing resources, much clearer.

This will be the last StrategyAudit post of 2017. I am very grateful to those who have commented, shared and generally engaged with the sometimes random stuff that pops out of my brain, and I am enormously gratified that you see the value in the ideas. Have a safe and merry Christmas, and I will be back early in 2018, refreshed and eager to  go another mile.

 

 

 

7 Mental models for business planning

7 Mental models for business planning

Dec 18, 2017 | Governance, Leadership, Management, Strategy

Business planning, when you think about it is a  bit of an oxymoron.

The only thing you know for sure about your plan is that it will be wrong.

George Patton said ‘Without a plan, you are just a tourist’ and even that great social philosopher Mike Tyson weighed in with ‘everybody has a plan until they get hit in the face’.

However we persist in writing what is usually a document full of crap that is not looked at again, until next year.

Here I am going to offer you an alternative to the formatted, templated, disciplined plan, so beloved of accountants, banks, and education institutions. I am going to suggest you use ‘Mental Models’ to ask the right questions, gather information, generate insights, create strategies that are meaningful, implementable and measurable.

Albert Einstein used mental models to develop his theories of relativity and quantum physics.

If employing mental models is good enough for Albert to articulate a picture of uncertainty, ambiguity, and then hypothesise about its hidden drivers, it should  be good enough for us.

Mental Models are frameworks that can be used to simplify problems, to ensure that the right questions have been asked, and the explanations that evolve from those questions hold when subjected to detailed scrutiny and testing.

Mental models frame things.

As a kid I loved cricket. I would walk to school early, and play for a couple of hours before ‘the bell’. As I came up to the oval attached to the school, when someone was batting, I could see the stroke, then a second or two later, hear the bat hit the ball. Clearly there was something at work here I did not understand. Dad explained it by telling me that sound travelled at 740 mph, while light, which enabled me to see the stroke travelled at 186,000 miles per second. This meant the sight was instantaneous, the sound was not.

Hearing the bat hit the ball a second or so after seeing it hit the ball created a mental model that made the understanding of the effect of the differing speeds of light and sound absolutely clear. Had I been a mathematical kid, I could have measured the speed of sound by measuring how far I was from the batting crease, divided by the time it took for the sound to reach me. This is exactly what Albert did to come up with E=MC2, although a little more complicated.

Einstein used simple mental models to come up with his theories of relativity, then worked his way through the maths to test and ultimately validate the theories mathematically. It is only now that some of the stuff he hypothesised about is becoming confirmed, as the measurement of the effects he hypothesised are becoming available.

The origins of the business plan was to attract funds. If someone was going to lend you money it is reasonable that you told them where you would be spending it, what the risks were, and the means by which you were going to repay the debt.

Banks, which are usually the first port of call when seeking funding are not particularly interested in your success, they are interested in the asset backing you have, so that when you go broke, they can sell up and get their money back. They would prefer you did not go broke, just because that complicates their lives, but they ensure they are covered if you do.

Banks are not your friends, they sell a commodity: money, and like any sales organisation, will sell as much of it as they can within their risk parameters and any regulatory restrictions, by solving your cash shortage for you.

Therefore the standard P&L, and balance sheet projections, with a few discounted cash flow scenarios were enough. All accounting and management education was oriented towards this model, so it became widely used and abused, but if you are going into a serious business planning exercise for your business, in this homogenising and increasingly volatile world, it should not be enough for you.

Do  not think about business planning as a linear incremental process, with a known set of tasks to be done, which is what all  the templates assume. Rather, it should be the application of a series of mental models to the circumstances of the business, each looking at the business from a different perspective.

It is like looking at a display in a museum. Looking from the front only, you get one view, but go behind, under, above, and you can get a 3D view of the display. Often very different, and ensures that you capture the whole picture of the business.

To continue the museum exhibit metaphor, is the exhibit in a room of its own, is it in a quiet corner with other pieces of no distinct value, or is it in a room full of similar and complementary exhibits. Each will influence the way in which you see the exhibit.

Out of interest, I googled ‘Business plan template’ and got 9.4  million responses in .45 seconds.

Must be important????

Problem is when you look at  them, they are all pretty much the same. The words change, the graphics change, but they are essentially a fill in the form and bingo, a business plan.

Might be OK for a bank, but as a document that determines the allocation of your scarce resources to achieve an outcome, it is next to useless.

A template is the easy way.

The hard way is really hard, but is worth the effort,

However, you must have the right ingredients, or the cake will not work.

It is all about the questions you ask, and what you do with the resulting information, intelligence, and instinct.

So, take Alberts advice, which is also the advice of Charlie Munger,  Warren Buffets offsider who knows a thing or two about being successful, and who uses Mental Models extensively.

Following are some of the more common ‘Mental Models’ to apply.

Each has its strengths, but none is the silver bullet that those who write books about them claim them to be.

The trick is to be familiar with them so you can run through the models and pick the ones that apply to any given situation.

 

Most are familiar with SWOT.

We spend time dreaming up items, then filling in boxes, rarely with any useful numbers, rarely anything new, and everything is equally weighted.

Most times, there is as much debate about whether something is a strength or an opportunity, a weakness or a threat, as there is about the strategic impact of the item itself. Many do not recognise the distinction of strengths and weaknesses as being internal to the business and opportunities and threats as being external, and that they are all relative. For example, a strength is really only a strength when it has two distinguishing features: It is something that you do that your competitors cannot do, or chooses not to do, and that it is of value to customers.

SWOT has limitations in fast moving and technically evolving industries, and typically, there is insufficient time given to the consideration of the options that may emerge that offer some degree of differentiation.

In its generic form, a SWOT also fails to weight the factors it identifies, so I do that as well in a different table.

Because SWOT is well known, it often gets a run in the projects I do, almost always in parallel with another that better explains the problems, and offers another perspective. It is a good start to the process because it acts as a catalyst for the more difficult questions, and identification of the cause and effect chains, and eventually to the use of other models that drive a deeper analysis.

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Many will be familiar with the 5 forces that shape industry competition first articulated by Michael Porter 30 years ago, and still is a great way to examine the nature of the industry in which you compete.

Bargaining power of suppliers

Bargaining power of buyers

Threat of new entrants

Threat of substitution

The sum of these forces adds up to the state of current competition in any market.

A thorough examination of the forces really surfaces most if not all of  the issues that have to be faced.

When you think hard about it, everything can be broken into one or a mix of the forces.

As with SWOT, it suffers a bit in a fast evolving environment, as the searching questions about the future are often missed, but it is extremely useful.

For example, if you are a supplier to supermarkets, this is a great tool to use, as it captures the drivers of the competitive environment, but if you have an idea for a new piece of software, the outcomes of the analysis will be a little less certain because of the more ambiguous competitive environment.

 

Roger Martin is an academic and widely experienced commercial consultant, who wrote a book a short time ago called ‘Playing to win’ with AG Lafley, who was the CEO of Procter and Gamble.

This sequential process he outlines is a very good framework indeed, forcing difficult choices to be made at each stage before moving on, while encouraging necessary adjustments via the feedback loops.

One of the factors I really like about this model is that it creates a flow, from the macro to the micro, and forces you to make choices all the way. One of the key factors I look for when doing a StrategyAudit for a client is the manner and degree of ‘flow’ that exists in the business.

It is the flow of information, flow of product through a production process, and flow of the planning execution and revision of activities that take place.

 

The Balanced Scorecard goes back to the mid 90’s, and offers an integrated set of ‘perspectives’ through which to observe, measure and plan the business.

You agree the vision and strategy, then determine the measures of that strategy against the 4 perspectives, and map the interrelationships.

Balanced scorecard analysis can become very complex, particularly as you set out to  cascade it through an organisation.

However, It makes absolute sense to look at, and measure the strategies agreed upon from the perspectives of those perspectives impacted by choices made.

The financial performance of the business.

The customers perspective of how the business meets their needs, now and into the future.

The necessary business processes required to deliver value over the long term as well as immediately.

How the business will learn and grow.

It is still widely used, mostly by large organisations with centralised strategic planning functions.

 

A business plan on one page.

Halleluiah.

This methodology evolved quite recently out of the ‘Lean Start-up’ movement, first articulated in a book called, surprisingly, ‘Business Model Canvas’. The thinking underpinning this tool is still evolving, and it is still oriented towards tech start-ups, but I really like it for any business as a way to quickly ensure the right questions are being asked, and is to my mind a must use model.

It is designed to be iterative, and its strength is that it is both iterative, and stackable, in that where there are two major customer groups, or product groups in a business you can do two, or even more canvases, and they will all be stackable.

It forces choices to be made, and is iterative in that as you progress, and learn more, you often need to go back and review and balance the choices made earlier.

Generally I do this in a rough order.

  • Problem to be solved
  • Customer segments
  • Value proposition
  • Revenue streams
  • Key activities
  • Cost structures
  • Channels
  • key resources

 

There are many others:

  • Ansoff matrix,
  • BCG matrix, dogs, stars, that most of us are aware of.
  • Options games
  • Blue ocean strategy
  • Scenario planning
  • Jobs to be done
  • A3

The real point is that there are many ways to plan, but there is no easy way, no silver bullet, and you must get amongst it or fail.

The old cliché: failing to plan is planning to fail is unfortunately correct.

There is no school for fortune telling, unless you join the circus. All these purport to be able to at least remove some of the uncertainty of dealing with the future, but they are all tools, and the value of a tool rests with the skill of whoever is wielding them.

To my mind, using a bunch of them, each with slightly different perspectives offers the best opportunity to remove more of the uncertainty.

However, if I go back to Albert, E=MC2 does predict that time travel is possible.

Much of what he projected is coming true, a bit like Arthur C Clarke, Jules Verne, and others. Perhaps this is Alberts time to become a strategy guru?

 

I think it is only right to finish where I started, with Albert.

His theories of relativity, that famous formula we all know, but have no idea what it means, explains the workings of the universe. Perhaps it can also give us an insight into the value we can add to an enterprise, which is after all, what we are setting out to do by planning.

In my view, the internet has changed everything about the business models that will be successful in the future. Therefore we have to find a way to recognise the power of digital access and the compounding that is possible by leveraging networks in our planning processes and mental models.

I like e=mc2 because it explicitly compounds the value of networks.

E is the enterprise value, not the stock market valuation, which is only a financial calculation, but the value that is created by the enterprise, which has many forms. Value can be time, services, transparency, design, everyone sees value as being different, and is subject to the context in  which it is seen. Apple is the most valuable company on the planet, which has absolutely nothing to do with the fact that they outsource the manufacture and assembly of what has become generic electronic gizmos. The value of Apple is elsewhere than the functionality of the devices.

M is the mass of the enterprise.  This is the sum of the physical assets and processes of the business, the stuff that enables the work to be done.

C is the Capital of the enterprise.  It includes financial capital, but the greater part is in the capital contributed  by  the people who populate the place, and this comes in many forms, Intellectual capital, what is between peoples ears, and the relational capital they bring, and the cultural capital, the way in which there is collaboration and alignment of activity towards the creation of value by the enterprise. This is squared, simply because of the geometric nature of relationships, and the network effect, the more you have, the greater the sum of the value that can be created

 

Red flags to business failure.

Red flags to business failure.

Dec 11, 2017 | Change, Governance, Management

The November 2017 issue of the magazine of the Australian Institute of Company Directors (AICD) contains a very insightful and useful article by Phil Ruthven dealing with the industry cycles that IBIS research has been cataloguing for 40 years.

Ruthven makes the observation that while industry cycles are crucial to success, the risk they pose is only 1/3 of the risks faced by businesses, the other 2/3 are internal risks, in short the quality of their management.

No real surprise there, but seeing it in black and white, with supporting numbers from a source as credible as Ruthven is disturbing.

ASIC has developed a list of the impending signs of insolvency, no surprise, as they deal with that situation every day. High on the list is poor cash flow, absence of a business plan, disorganised internal finances, inadequate cash flow forecasting and budgeting, board dysfunctionality, customer and supplier complaints, and growing liabilities.

Again, no  surprises in this list, I have seen them all regularly over the last 25 years of working to improve SME performance.

I have my own checklist, broken into 4 categories: Financial, Operational, Strategic and Revenue Generation, against which I assess performance. It is a quick and dirty tool that over the years has captured the main culprits of underperformance, the red flags to insolvency.

It is reproduced in summary form below.

Strategic.

  • Unclear undifferentiated position in primary markets
  • Lack of investment in ‘Environmental research’
  • Absence of an innovation mindset
  • Absence of any differentiating Intellectual Capital
  • Lack of clear alignment of operations and strategic priorities
  • Wrong CEO and/or governing body
  • Poor cultural drivers
  • Poor strategic, operational and tactical planning and ‘After Action’ Review processes

Operational

  • Ambiguous lines of responsibility and accountability
  • Absence of a continuous improvement mindset
  • Absence of performance management and review systems
  • Unreported customer and supplier complaints
  • Absence of DIFOT management and measures
  • Digital naivety

Financial

  • Erratic and unforecast cash flow
  • Poor management of debtors and creditors ledgers
  • Inadequate budgeting and financial performance management
  • Disorganised and/or inaccurate numbers
  • Tightly held financial and operational performance reports
  • Growing debt
  • Lack of financial understanding amongst management

Revenue generation

  • No defined ‘ideal customer’
  • Uncontrolled distribution channels
  • Lack of end consumer contact and feedback
  • Disorganised lead generation and conversion  processes
  • Absence of customer profitability and Share of wallet measures

For some time now I have been referring to the marketing and Sales functions collectively as ‘Revenue Generation‘. To my mind the functional separation that is usual is redundant in this fast moving world where the demarcation between the two is both blurred and irrelevant to customers, so should be eliminated.

This list is not a template, it is a compendium of headings that typically require investigation. To the extent that there are numbers available, they are very useful, and the absence of numbers also offers an insight into what is going on. I also make observations based on the conversations I have, and set about weighting of the various factors. Two however always are at the top of the list.

The absence of routine and pro-active cash management is a very strong signal of trouble to come, as is a disorganised, and in B2B businesses, often absent revenue generation processes that go beyond being reactive to whatever walks in the door.

Any one of these 26 factors will result in under-performance, that can lead to insolvency, but a combination of them is toxic.

 

5 questions that might save Australian manufacturing

5 questions that might save Australian manufacturing

Nov 23, 2017 | Change, Management

 

The news that Murray Goulburn would be acquired by Canadian dairy giant Saputo, taking out the largest of the few remaining Australian owned  FMCG manufacturing businesses is not welcome, while probably an inevitable  result of the failure of Australian management and our institutions to meet the challenges of change and globalisation. It leads me to consider what is next for manufacturing and specifically FMCG manufacturing in this country.

It is not a pretty sight, coming on top of the final closure of the car industry a few weeks ago.

Having said that, manufacturing that will be profitable and provide the foundations of our economy for the rest of the 21st century will look nothing like the manufacturing we grew up with, so my greater concern than the demise of what we had, is how grossly unprepared we seem to be for what is coming.

The tsunami currently washing around our ankles seems to have three  characteristics:

  • The gigantic increases in the volume of data available to us, should we be willing and able to collect, communicate, analyse and leverage it via the analytics and business intelligence tools emerging in parallel.
  • New forms of machine/human interface being driven by touch and voice.
  • New ways of transferring the digital tsunami into the physical world, by means such as robotics, artificial intelligence,  augmented reality, and additive manufacturing.

It seems to me that we are ready for none of these except in isolated pockets, inhabited by a few really smart people unwilling to be drowned, and prepared to bet the farm on the future.

So, the questions to be faced by those who will either survive, or more likely emerge from the rubble (assuming the ‘policy-makers’ do not stuff it up entirely) may be something like the following:

1. How can we capture and make better use of information. The currency of the 21st century is information, but by itself, it is just lead in the saddlebags. What counts are the insights and leaps of logic that can be gained from the information that leverages it into useful knowledge that can be monetised.

2. Which strategic questions should we be asking ourselves? Which questions will offer the opportunity to make the right choices and develop the insights into what may happen next, as the value of using the past as an indicator of the future is long gone?.

3. What might the new business models look like? It is certain that the business models of the past are as redundant as a Model T in an F1 race, so we need to be actively developing and testing a new breed.

4. What sort of capabilities will be needed to compete sustainably? Where are we going to find, train, and retain the people with those vital capabilities? The tools and technology are increasingly becoming commoditised, the people who use them will be the differentiator. At the core of this question is how we manage the education of our kids. it seems to me that education is viewed as a cost to the budget, a line item to be argued and manipulated with a short term focus, rather than as an investment in future prosperity, which by definition will be generational. We need to teach our kids to think, to be critical and analytical, while trusting their instincts and domain knowledge, and if we fail in that, we will have failed completely.

5. How do we collaborate? This question has caused many sleepless nights to date and we still have no real idea beyond the clichés and academic prognostications. Australians are lousy at collaboration, we see the bloke next door as the enemy, or at least someone to be avoided, you certainly do not invite them to dinner, and to date your daughter. However, we need to get over this and be prepared even to collaborate with competitors in some areas, and the regulators need to get used to the idea by taking a broader view of the definition of competitive advantage.

All this is a long way from the demise of the Australian FMCG industry, as I have variously  chronicled in these pages, but it is also tangled up with our collective failure to see the future through any lens that gave us the insights necessary to dodge the hand grenade of change, and take advantage of the subsequent explosion.

Only by questioning the status quo, recognising it will not be an indicator of the future, and genuinely setting out to make the often radical changes necessary will Australian owned manufacturing survive as a significant contributor to our continued prosperity.

 

 

 

 

 

 

 

 

The right tool is still not enough 

The right tool is still not enough 

Oct 30, 2017 | Change, Governance, Management

A huge impediment to effective and ultimately successful marketing is our obsession with the tools, especially the new and shiny ones.

My father was a very keen golfer who practised and sweated for years to get his handicap down to 20. One of his mates was a very good golfer, could easily do a round within 5 strokes of par with Dads clubs.

Same tools, different user.

Marketing tools are no different.

While every tool has its limitations, you would not use a sand wedge off a tee except perhaps on a very short uphill par 3, the skill of the user also has a profound impact on the outcome.

A tool is just an item that gives you leverage, able to do more with less, how much more depends on the skill of the user.

Every business uses a range of tools to deliver leverage, it is the means by which they scale. However, just having the tools deployed and at your disposal is nowhere near enough. The winners are those who extract the most value from them.

 

 

The getting of wisdom

The getting of wisdom

Oct 16, 2017 | Governance, Leadership, Management, Strategy

As I get older, the world seems smaller, more complicated, but smaller. This is not just the technology we all now have that has shrunk all the boundaries of our world over the last 20 years, putting the all the  information anyone has ever had at our fingertips, that is different.

It is one thing to have all  the information, it is quite another to be able to make sense of it.

There has been a progression from data to information, to knowledge that has been recognised and widely leveraged, but now there is another level to the cake, wisdom.

We all have access to the same information, can find those who have the knowledge to use it, but it is wisdom, born of experience and breadth of thinking that delivers the wisdom now so rare, but so sorely needed.

I like very much the philosophy of Charlie Munger who talks about mental models, ways of assembling knowledge and sifting through it, reorganising it to be seen from different perspectives that offer a different view. The more mental models you can bring to bear on a topic and body of knowledge, the greater the chance that there will be some insight that emerges unexpected from the model.

Charlie speaks of his mental models, and their source often, a man of few words, leaving most of them to his mate of 50 years Warren Buffet. However, in 1994 he wrote what has become a staple of business thinking , his ‘Worldly wisdom’ speech.

As a kid, we learnt stuff by experience, and using mnemonics,  devices to assist us to remember things. Rhymes, associations, colours can all play a role. Wisdom seems to me to be the opposite end of the mnemonic, the ability to see connections between seemingly unconnected pieces of information, and it is our mental models that enable these connections to be made.

By contrast what we have often these days are unrelated facts presented as a cause and effect, or a set of actions that worked in one place being expected to work in another, which may seem similar, but at a deeper level are not sufficiency similar to enable the actions to deliver the same outcomes.

We tend to be a society that believes, or wants to believe  in miracles, perhaps cargo cults, because it is easier than doing the hard thinking yards.

As someone who gives advice for a living, it is incumbent on me to have a clear framework from which to distil the information to have into advice that is tailored to the needs of those being advised. As often as not, the advice is not heeded, or taken in parts which sometimes hurts, as it reflects poorly on the end result, but it is the reality of making real change.

To be able to deliver the unwelcome news with confidence that it will hold, I need to have a range of mental models, models that come from the work done over 45 years in marketing, sales, operations, leadership, logistics and accounting, and be able to filter the information in front of me through the range of models in a routine and organised manner. Each model gives a slightly different interpretation of the facts, a different slant that requires consideration, so that each outcome is slightly different to the past, but best fitted to the situation to hand.

When you need a bit of wisdom, give me a call, perhaps I can help.

For context, vital in the consideration of Wisdom, the blurry photo is of a group of islanders in the Pacific at the end of the war. People on remote islands had become used to planes going overhead and dropping supplies to the troops. When the war ended, so did the dropping of supplies, an outcome not anticipated or understood by islanders. Physicist Richard Feynman gave it the name we all know: ‘Cargo Cult ‘in a speech in 1948.