Will your automation business survive, thrive?
Engineers like numbers but often find accounting obtuse. Paying attention to a few key metrics can save a profitable engineering-related business from doom and make the workplace more satisfying for all, suggested Nick Setchell, CEO of Practice Strategies. Setchell talked about the “RealTime CEO – Maximizing Real Business Value,” at the 2013 CSIA Executive Conference, providing insights into accounting best practices for engineers.
The consultant, from Adelaide, SA, Australia, explained to system integrators that company leaders need a balanced understanding and application of 1) strategy and vision, 2) leadership and motivation, 3) finance, and 4) operations. Many leaders, especially those in mid-market companies (MMCs) with engineering backgrounds, have the most expertise in operations, then in strategy and vision, followed by leadership and motivation, with often little knowledge of finance.
Employees or third-party accountants hired to fill in the gaps usually don’t explain what they often assume others know. Tragically, profitable companies can go belly-up before leaders realize they’ve missed key indicators, such as cash flow, that are not entirely obvious in traditional accounting methods.
“We want to shape future by acting now in real time. How you choose to deal with challenges will define you as a leader,” Setchell explained. Frustration, he said, often stands in the way of success. “Find the silver lining in every cloud and run with it.”
Balance, before bankruptcy
He discovered during time as a turn-around consultant that ultimately, only two things are relevant: Cash flow and people. Looking at related metrics before a company gets to the brink of bankruptcy can help companies run more effectively. Balancing time spent in four areas provides a good start.
1. Strategize daily. Most leaders have 20 undone things from yesterday and 80 more from today. Strategy and vision can get pushed aside.
2. Motivate those around you.
3. Understand operations (be good at what you do). Companies rarely underperform because you don’t have good operational skills.
4. Understand finance.
Illustrating the importance of organizational balance, Setchell asked, “Which of the following columns provide the best support for a structure?”
Obviously, the column on the left is ideal…and, unfortunately, rare.
Improve in four ways
Setchell provided some questions in four areas to consider improving balance.
Foundation: Why do you exist? (Don’t just answer, “To make money.”) Is your business foundation able to support your future vision for next two years of massive opportunities, during the fastest rate of change yet? If the foundation is not strong, a company will collapse. A painful; example of this was Enron that fooled many smart people for long time. If nothing else, celebrate weekly that you’re still here. “If all you do is grumble, then employees will suffer and productivity falls.”
Operations efficiency: Can your operations engine produce timely, high-quality output? Companies not well positioned for a downturn wind up cutting employees and then, even if they survive, can become part of a second wave of bankruptcies as they try to grow too quickly with limited resources and funding. Like people, a company will choke more quickly than it will starve. Growth at 10%-14% is better than 50% with the wrong pricing strategy. Market leaders (like a salami company) can go out of business in five days after having a “small” problem with botulism.
Market: Who are your customers? Are your sales and marketing strategies complementary? Sales is tactical, to identify and close deals. Marketing is strategic, to create a desire to do business with you. Why is marketing an afterthought for most businesses? Part of putting strategy before tactics is that companies should have a clear pricing strategy related to their dominant competitive advantages (DCA), meaning, “Why you should buy from us, and not others.” Most MMCs don’t have one, and those that think they do often answer, “Good customer service.” A DCA is something you can say that your competitor cannot.
People: Do you have a validated a way to evaluate people to ensure effective communication and performance? Few leaders have psychology degrees, though there are many tools available to help with this greatest asset. Scary, but too-often true, is the saying, “Whippings will continue until moral improves.” Tolerating the wrong people within an organization can suck energy out and suffocate innovation.
3W: What, by whom, when
Some core management principles to implement are:
Action responsibility using 3W accountability, which is defining what will be done, by whom, and when. Let who define when, but then hold the person or team accountable for that. To provide instant accountability, every meeting should start with 3Ws from the prior meeting. “Sorry, Nick, I was too busy to get that done.” That is not acceptable answer. The rest of us were not sitting around scratching our butts. If you cannot finish, you need to ask for an extension. Within 2 weeks, this teaches people to make deadlines. You’ll learn who is legitimately overwhelmed and who is taking you for a ride.
Entrepreneurial measurement of fiscal focus: Do you really understand accounting? Do you really want to? Setchell has short list of key fiscal indicators to keep from going belly-up without noticing. (He started his career in a Big 8 accounting firm.)
Decision validation: Validate your gut feel with a mechanism that enables you to ask two key questions for each major decision – “Should we do this ? Can we do this.” While “gut feel” decisions may go serve well for a time, they can sink the company.
Strategic investments: Use J curve management for key projects, to avoid dropping dollars through the cracks or spreading your organization and people too thin.
Risk management: Use real-time planning.
For chief executive officers, creating value and mitigating risk are the only two responsibilities, Setchell said. Most CEOs are inclined to one or other. Balance is challenging.
A leader of a software company had to fire an “Einstein-brilliant, hard worker” who was in late daily (though worked more hours than everyone else) and regularly did things his “better” way, rather than following individual, team, or company best practices, regularly upsetting everyone else. After his departure, productivity went through the roof.
A sensitivity analysis can help identify how can to allocate scarce resources. Companies fly blindly when they don’t know how changes will affect the business.
Price is the most powerful driver of change and is a double-edged sword. Discounting is the fastest way to destroy a business.
One of the least powerful ways to change is to reduce indirect costs. When a crisis hits, most companies cut indirect costs. How you make investments will make be a massive determinant of how much value you can create during the next 2 years of huge opportunities.
If you change 1% in key areas, what happens? Rank them and put most the most sensitive on top and least on bottom. In one specific example, a 1% price increase can increase profitability almost 4%. Increasing work (volume) by 1% creates a 1% gain. This shows that for system integrators (and many businesses), price is at least four times more important than volume. Dropping prices and increasing volume won’t work. Businesses often fear increasing prices for fear of lost sales. Do not set your strategic direction by the rants of the weakest salesperson.
Frequently challenge the critical question: What is and how suitable is our pricing strategy? Match your pricing philosophy with your product delivery strategy. For example, a little blue box from Tiffany is very expensive, so Tiffany sells less than Walmart. Walmart can drop prices until it picks up every sale in the world, but do NOT sell Tiffany products at Walmart prices. You will fail. This is the most common reason for failure. Set your pricing strategy by the strength of your DCA, by the strength of your brand.
An exercise showed how, at one company, 10% higher prices allow greater investments in supporting DCA and margin, while lower prices erode margin, increase volume, require much more work proportionally for a smaller margin, and strain resources to pick up what could be “pain in the ass” customers, according to Setchell.
Impact of price discounting: If you give away half your margin on each sale, then you may have to work twice as hard to get back to your previous levels. Mathematically price increases normally benefit a business; price decreases harm it – this is the opposite of conventional wisdom.
Manage J curve investments: Companies invest money now in something not immediately profitable to gain benefits later. The J-shape of the curve happens as the activity 1) is cash flow negative for a time, then 2) is cash flow positive in the short term, but still negative from start of the project, and then, if successful 3) is cash flow positive over the life of the project.. The idea is to minimize the depth and breadth of the valley, move to phase 3 as quickly as possible, and not undertake too many J curves at once, which can kill a company. J curves include a new product launch, equipment purchase, acquiring a competitor, expansion, location change, or a new hire. Are you prioritizing and managing cash flow related to J curve investments? Few businesses have a defined way of tracking J curves. Caution: Do not become emotionally attached to any project, riding it to the bottom. Watch for flat-liners and pet projects that are ski slopes to the bottom. There must be a predetermined point for any project past which you will not put in any more money.
For example, there are three phases of recruitment: faith, hope, and charity. Faith that they’ll work out, hope that they’ll work out, and charity, past which point, the person is not only costing you the price of salary and any benefit, but also dragging down others.
Next page has more accounting advice for non-accountants: See more on value and timing of projects and a cash-flow testimony.
Do NOT take on too many J curves at once, because a company can stall with too many, no matter how brilliant the next idea is. Will the next J curve add value, AND is it the timing right? Questioning the logic of a J curve today with today’s logic doesn’t mean you are questioning the original decision.
For example, closing a gold mine at $400 an ounce might have made perfect sense, but the decision can require reconsidering after gold prices exceeded $1000 per ounce. At the time Rolls-Royce went bankrupt in 1972, Setchell said, it was developing 35 jet engines, spending 40% of its resources working on projects that were not returning profit.
Albert Einstein is attributed with saying, “Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted.” Numbers are the language of business. Leaders need to equip themselves with numbers that provide key metrics. A balance sheet is difficult to understand and doesn’t provide an easy snapshot of a business’s health.
For each $1 of investment how many dollars of revenue can be generated and for each $1 of revenue, how much profit is there? With the given risk of an activity, is the return sufficient? Is enough cash flow generated to continue being an entrepreneur? These are important numbers that accountants don’t provide.
Traditional generally accepted accounting principles (GAAP), using traditional income statements and balance sheets can hide what’s really going on in a company. Setchell said company leaders need to focus on return and cash flow by looking at:
- Percentage return on operations (ROO, a measure Setchell made up, is a simpler measure than return on capital employed, used by many large public companies.)
- Percentage of operational cash
- Revenue leverage rating
- Revenue profitability rating.
Those have eight “fiscal focus levers,” according to Setchell, that practical actions can target. Four have to do with the ability to create revenue or input leverage: revenue collection, inventory management, supply chain management (the accounts payable relationship to suppliers), and fixed asset utilization. Four have to do with reasons for creating revenue or output leverage: price strategy, direct cost control, indirect cost control, and volume strategy.
Avoid self-delusion. Numbers must include the actual costs of company leaders or founders, even if they’re not taking full salary and benefits. Cash flow is the lifeblood of a business. If profit is like food to a business, then cash flow is oxygen. You can live for a little while without food, but not very long without oxygen. Anyone ever place call to customers on Thursday to make payroll on Friday? That’s too close for comfort and why cash flow is important.
Each action relating to the eight levers impacts cash flow. The cash-flow calculation is money in and money out, like rainwater in a tank. If you can buy supply chain items on credit, that creates good flow. Selling on credit, creates more pressure on flow. Operational cash flow statement is best tracked over a 12-month period. Total money in is revenue.
Operational cash flow, if negative, can be an early warning liquidity problem, showing that a company could be profitable but going broke. Looking at only revenue and profit means that the company could go broke without anyone noticing. “This reporting format creates through-the-roof performance,” Setchell said.
Think of ROO percentage of an interest rate of return for dollars invested in a business, perhaps the “most powerful single number to measure business success,” Setchell said. Looking at business with these tools provides a roadmap to strengths and weaknesses and a decision validation tool, with numbers entrepreneurs can understand. Seeing input versus output shows how input is the investment and real operating profit (ROO) is the output after calculating for expensing with owner salaries and the like. Revenue/investment x real profit/revenue = ROO.
“Using this formula makes any business more valuable. I’ve done this more than a thousand times. It works.” Decision validation helps people understand what to validate and what to ignore. Are we able to fund this decision without jeopardizing our future? Should we and can we? You need a “yes” on both before saying “yes” to a decision.
An example looks at what a business can do with money rather than what money costs the business. Don’t get talked into a logical decision if it’s wrong, Setchell said. It may be advantageous to offer to pay your supply chain instantly if they will discount by 2.2%-5%. Do the math within your supply chain in both directions, he recommends.
Cash flow testimony
Adrian Fahey, CEO, Sage Automation, who has worked with Setchell to improve business decisions in his 300-person company, noted that cash is king. With most engineering businesses, Fahey said, 90-120 days for receivables is usual; moving that to the high 50s or low 60s performs very positive results.
Knowing the cost of decisions helps to more effectively position a company for downturns and accelerate more quickly during economic expansion. “When the rest of market headed for the hills, we pumped money into our business, contrary to conventional wisdom. Now we’re enjoying stronger returns than competitors,” Fahey said.
Parting advice from Setchell: For CEOs to succeed in today’s market, they must:
- Develop a balance of experience and desire to learn and broaden skills.
- Have healthy thirst to learn new stuff. Understand quadrants of business drivers to target personal development in company leaders.
- Define and harness the foundation of the business
- Challenge and influence market (across the organization)
- Understand and challenge management of people
- Make and follow procedures for operations
- Implement core management principles to maximize value
- Hold teams accountable with 3W action management
- Understand measurements focused on creating value
- Make more effective decisions (should we/can we)
- Hold strategic investments accountable by managing the J curves
- Learn from the past to influence the future.
About the conference, CSIA
More than 500 attended the 2013 CSIA Executive Conference, CSIA said, exceeding the 2012 record of 470. Founded in 1994, the Control System Integrators Association (CSIA) is a not-for-profit, global professional association that seeks to advance the industry of control system integration. Control system integrators use engineering, technical, and business skills to help manufacturers and others automate industrial equipment and systems. CSIA members provide services for dozens of industries. Headquartered in Madison, Wis., CSIA helps members improve their business skills, provides a forum to share industry expertise, and promotes the benefits of hiring a certified control system integrator. CSIA has more than 400 member firms in 27 countries.
– Mark T. Hoske, content manager, CFE Media, Control Engineering, Plant Engineering, and Consulting-Specifying Engineer, with information from CSIA, email@example.com.
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