The Value of Stress Testing your Business

The act of “stress testing” banks, allows regulators to understand the effect on a bank’s economics during a severely adverse scenario, i.e. what is the likelihood that the institution will continue to transact business and survive a prolonged economic downturn.  Based on the results of the testing, regulators and bankers understand if the bank has the proper capitalization or alternatively what capital cushion is required to sustain itself.  Projecting an outcome based on a potential set of circumstances is a sound risk management approach.  Slightly modified, this approach can be and should be used to assess the impact of a stress on your business.  Does your business have the proper capital reserve cushion to adjust to a shock for a prolonged period?

For example, in the next three to twelve months, it is highly likely that the Federal Reserve will increase the federal funds rate.  This tool of monetary policy has an indirect impact on the prime rate, as the rates tend to move in lock-step.  As such, borrowers with variable rate loans will find their borrowing costs increase, i.e. a shock.  Since January 2009, the prime rate has been constant at 3.25%.  Yet 24 months prior, the prime rate was 5.0 percentage points higher, i.e. 8.25% (Source: Federal Reserve Board, Proprietary Bank Surveys).  At this point it is unclear if the Federal Reserve will begin a campaign to raise rates in 2015.  But once the campaign begins, how far will rates move up is not known.

To understand the potential impact of this shock, a business may perform the following testing –

Develop a proforma model based on the cash flow of your business.  Now increase your interest expense by 50% and then by 100%.  What is the impact on profitability as interest expenses increase?  Businesses that will be most impacted directly are entities that currently utilize a high amount of leverage and/or businesses that lay money out in advance of sales, for supplies and inventory.  While a business may have control over its leverage and purchases, it cannot control the economics of its customers and clients.   As rates increase, the economics of your customers may be disrupted which will have a trickle-down effect to its suppliers, i.e. you.  The natural outcome may be payment delays and an increase in your bad debt expense.

Based on your model, understand when issues will arise.  Quantify how much additional cash is required to ensure the proper cash reserve cushion is maintained.  Next proceed with one of three options –

Option #1 Least Impactful – Do nothing.  Understand the theoretical shortfall, but only make a change when you feel it is absolutely necessary.  I have seen many businesses use this wait and see approach.  It is not recommended.  Admittedly however, sometimes doing nothing works; but, other times it is disastrous.

Option #2 Most Impactful – Understand the cash reserve shortfall and discontinue any partner/owner distributions until the desired capitalization level is achieved.  This approach is very much in line with how the bank stress tests are performed.  If the bank passes the stress test, the Federal Reserve may allow it to make dividend distributions, share repurchases and major acquisitions/divestitures.

Option #3 Recommendation – Understand the cash reserve shortfall.  Investigate ways to increase the efficiency of your business.  Logical places to begin include –

  • Remove all non-value added costs – A non-value added cost is an expense that is incurred, but does not add to the value or perceived value of your product or service.  Simply stated, it is a cost your customers will not want to pay.
  • Ensure an appropriate pricing model – Pricing is a critical task that all businesses manage.  However, there are many different ways to approach the pricing requirement.
  • Review the demand for your product offerings – Periodically every business should review its product lines and services, to understand the profitability generated.  The natural result will be an emphasis on the most profitable activities; while de-emphasizing the less profitable or money loosing activities.
  • Remove discounts offered – Discounts have their place, but more often than not, they are used incorrectly.
  • Manage the vendor expense closely – Unchecked, vendor expenses can quickly become out of control. Are you spending more than you should be with your current vendors?
  • Review the profitability of customers – Obtaining a customer that becomes unprofitable is a common situation.  It only becomes an error of management if you do not periodically review these relationships, or ignore the results.

At this early stage, take advantage of the time you have to make adjustments to your business model to help absorb the shock and continue to thrive.  If you review the six areas listed, but are unable to find cost savings and efficiencies, you may need to fall back on either Option #1 or Option #2.

 

Author: Regis Quirin
Visit Regis's Website - Email Regis
Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.

Pay versus Performance – A Comment Letter to the SEC

Following is a letter that was forwarded to the Securities and Exchange Commission, in response to a request for comment, regarding the Pay vs. Performance proposal.

June 24, 2015

 

Mr. Brent J. Fields

Secretary

U.S. Securities and Exchange Commission

100 F. Street, N.E.

Washington, D.C. 20549-1090

RE: File No. S7-07-15

Release No. 34-74835- Pay for Performance (the “Proposing Release”)

Dear Mr. Fields:

Thank you for allowing me to comment on this proposal.  Overall I agree with the desire for greater transparency into the compensation vs. performance relationship.  The values identified to be used to demonstrate the relationship, would serve this purpose.  However, I am not in favor of the reporting flexibility for registrants, being considered.  I do not believe the flexibility will improve the data.  Instead the flexibility may create confusion and make it very difficult to compare registrant-to-registrant information by interested parties.  The flexibility also leaves room for the potential to unintentionally mislead.

When reviewing data (financial and statistical) there are several key elements that are required to provide confidence in the conclusions.  This situation is even more pronounced when you are comparing and contrasting the results across registrants – Is the definition of the data being reviewed consistent, for every registrant?  If I chose not to act today, when I review the information in a year or two, will the original definitions I used, be valid?  Is the data disclosed by the registrants trended over a consistent time period?

My overall recommendation is that every registrant should be asked to provide the same base information, in the same format, for the same time period.  Flexibility will be limited to a page or two of explanatory notes, subsequent to the tables.  I do not believe that these requirements create a burden in any way, as I would guess/hope that organizations perform a similar analysis currently when determining compensation levels.

Disclosure (Request for Comment #1 and #3) – Executive compensation and Financial Performance information should be included in all materials/filings that discuss compensation, including information to be distributed prior to an annual meeting or special meeting or written consent in lieu of a meeting.  There are multiple filings that a company may make to the Securities and Exchange Commission.  While an analyst may read several filing types, a shareholder or potential shareholder will most likely only read materials assembled for the purpose of the annual meeting.

Compensation Disclosure (#5, #22 and #24) – Executive compensation [as defined in (Item 402(c) of Regulation S-K [17 CFR 229.402(c)] assumes the completion of a Summary Compensation Table.  The table considers the multiple forms of compensation and should be required, with the values for each compensation component provided.  Interested parties can then see for example, what part of compensation is salary vs. bonus vs. equity….  Compensation information should be provided on an accrual basis, i.e. bonus paid in January for the prior year should be attributed to the proper year, to ensure executive compensation more closely tracks Total Shareholder Return.

Tabular Presentation (#6 and #12) – Reporting components should be defined and required, for both the Summary Compensation Table; and the Pay versus Performance table (page 19 of proposal).  The actual value of the components should be provided, not just summary or ratio information.

Graphic Presentation (#7) – A Line Graph should be included which shows for the five years under review the level of Total Shareholder Return (TSR).  Underneath the TSR line (broken vertical axis), would be a line to show the executive compensation, as a group.  You should expect to see the executive compensation line track closely with the Financial Performance.  The vertical axis can be broken again to show the median of annual total compensation (as defined by Section 953(b) of the Dodd-Frank Act), trended over five years, in relation to the annual total compensation of the CEO. In a perfect world, inclines, declines, and slopes will be similar.

Additional Information (#9) – Executives by nature will debate a financial calculation/statistic they feel does not positively represent their efforts, i.e. “But you can’t look at it that way.”  The difficult part is distinguishing the validity of that statement, i.e. perceived difference vs. actual difference.  As such, registrants must be allowed to append qualitative information to the quantitative data.  In a subsequent page, management can give an explanation of the information presented, i.e. why it is an accurate portrayal or not.  However, the goal is to have every registrant start from the same perspective, i.e. a level playing field.

Financial Performance (#34, #35 and #38) – Many ratios/statistics can be used to validate performance, which may include Total Shareholder Return, Free Cash Flow, Return on Investment, Shareholder Value Added…  Each statistic has its strengths and its weaknesses.  A claim that the statistic increases short-term approaches can be made for any measure that is used to gauge success.  Based on human nature, when a statistic is reported, managers will attempt to maximize the value.

Peer Group (#40 and #41) – The same peer group used for purposes of Item 201(e) or the Compensation Discussion and Analysis should be used.  A note should be included by the registrant that advises the interested party as to the components of the peer group.  If the registrant desires to make a change, the change must be made for both uses to ensure consistency.  However, if a decision is made to change the peer group, the data must be changed for all five years displayed.  This provision will avoid multiple peer groups in one filing.

Reporting Period (#42, #44 and #46) – All information should be provided for the most recent completed five fiscal years, without aggregation, consistently required by all registrants.  The time period is sufficient.  Additional years should not be allowed in the data page or in the subsequent notes.

In summary, there is a very real danger that the flexibility provided to registrants, which is being considered, will make the implementation of the Pay vs. Performance provisions confusing to investors.   In essence, if the rule was developed to assist investors, consistency, transparency and the ability to evaluate registrants is critical.

My recommendation is that every registrant should be asked to provide the same base information, in the same format, for the same period.  Flexibility will be limited to a page or two of explanatory footnotes.  I do not believe that these requirements create a burden in any way.

Please feel free to contact me if there are any questions with my recommendations.

 

Sincerely,

Regis Quirin

 

Author: Regis Quirin
Visit Regis's Website - Email Regis
Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.

The Problem with the McDonald’s Turnaround

On May 4th2015, McDonald’s Corporation  announced initial steps in a turnaround plan which included the following activities – restructure the business into four segments, beginning July 1, 2015 – U.S., International Lead Markets, High Growth Markets, and Foundational Markets; refranchise 3,500 restaurants by the end of 2018; capture approximately $300 million in annual general & administrative expense savings; and, embark on a three-year return of cash program to shareholders totaling $18 to $20 billion.

Other than the announcement of a turnaround, there was no complete turnaround plan communicated, i.e. what happened to place you in this situation and what is your plan to get out of it.  At this point, all we have to go on is a collection of press articles and press releases.

The clearest sign that turnaround assistance is required is after a steady erosion of your business economics.  The turnaround at McDonald’s Corporation is required based on the substantial economic drop in its business model, since 2013 –

As of Revenues ($000) Gross Profits ($000) Profit Margin
12/31/2014 $27,441,300 $10,455,700 17.00%
12/31/2013 $28,105,700 $10,902,700 20.00%
12/31/2012 $27,567,000 $10,816,300 20.00%
12/31/2011 $27,006,000 $10,686,600 20.00%

http://www.nasdaq.com/symbol/mcd/financials?query=income-statement

A business may find itself in need of turnaround assistance based on unforeseen external factors.  There are many reasons why an organization may require turnaround assistance.  Rarely is it due to a single factor.  The primary impetus for the McDonald’s Corporation turnaround requirement seems to be associated with competition from new entrants to the market and shifting consumer preferences.

In any turnaround, transparency and communications are integral for investors, analysts, potential franchise owners, rating agencies and employees.  When the turnaround is transparent, interested parties understand your direction and the value of the changes being implemented.  But absent this information, confusion is a high probability.  Based on a review of openly available information – some of the action items slated for implementation seem to be contradictions.

Steam-line menu

Variations and food options impact the speed and efficiency of the restaurant kitchens.  Testing is underway in Delaware, Little Rock, Waco, Bakersfield, Macon and Knoxville to simplify the menu and reduce options.  However, in another article you may read about menu additions planned or being tested, including all day breakfast, burger customization, a premium sirloin burger, and a premium chicken sandwich.  As of 2014, McDonald’s Corporation maintained 121 menu items.  Will the additions come before the reductions, further slowing down the restaurant kitchens?  What has the research shown with respect to the expected impact on customer satisfaction, from the menu reductions?

I believe that McDonald’s is a victim of it branding. The company is positioned as great tasting and inexpensive food. Where ever I go in the United States, I can purchase the same meal, with the safe quality. Most of us can repeat the ingredients in a Big Mac, i.e. two all-beef patties, special sauce… That is part of its branding. The slogan did not end with “or feel free to change it up.” The positioning – consistent quality, fast and at a low cost.

I do not think of McDonald’s when I want healthy or organic or custom fare. Very few brands have ever had success at a quality transformation. The only transformation that comes to mind is “Made in Japan.” That was not a positive in the 70’s. But in the 80’s, that all changed with the explosion of Japanese vehicles, i.e. Honda and Toyota. While it is not impossible, it is very expensive to re-brand.

Return cash to shareholders

On the heels of the recent year-to-year decline in profits from 2013 to 2014, McDonald’s Corporation intends to return $8 to $9 billion to shareholders in 2015.  At the same time, McDonald’s will be embarking on a turnaround which requires the use of surplus cash up front, to design new processes and launch new products.  For example, a new 31 page procedure to improve order taking and fulfillment accuracy was implemented in a Wyoming franchise, beginning December 2013.  The change was implemented to reduce the time to service customers, and increase customer satisfaction.  Based on its success, training and roll-out is slated for the summer 2015.  The role out of this new process to all 36,000 locations will require an investment by the organization.

Recently, the rating on McDonald’s Corporation debt was lowered by the three big rating agencies – Fitch lowered its issuer default and senior unsecured rating to triple-B-plus from A; S&P lowered its corporate credit rating to A- from A; and Moody’s lowered its senior unsecured rating to A3 from A2.  As McDonald’s debt ratings decline, the cost of borrowing will increase for the corporation.

Data Distribution

A redesign to turnaround a business cannot be completed behind the scenes.  Progress sharing with your investors, analysts and employees is very important.  But beginning July 1, McDonald’s Corporation will discontinue reporting sales figures monthly, and will begin to only report quarterly.  A turnaround usually results in a period of high analysis and the development of metrics to measure and manage the business.  Success at achieving your strategic goals, based on the metrics, is important to stakeholders.  Reducing the flow of information during a turnaround, may be counter productive to your efforts.

Once a Turnaround is announced, the focus should be on strategy, planning, cash flow, reporting, optimizing policies and procedures, marketing and business development.  However, currently McDonald’s Corporation is experiencing an attack on its brand from several fronts.  These attacks can be distracting and damaging in the press, when interested parties do not have a full understanding of your intended direction.  Examples of two such issues include – a Legal proceeding to determine if McDonald’s Corporation shares some responsibility for the actions of franchise employees, with respect to low wages; and The Children’s Advertising Review Unit claimed that McDonald’s Corporation advertising placed an emphasis on the toy that was part of the Happy Meal vs. the food in the Happy Meal.

I believe that McDonald’s Corporation would benefit if the turnaround plans were more fully communicated to investors, analysts, potential franchise owners, rating agencies and employees.

Author: Regis Quirin
Visit Regis's Website - Email Regis
Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.

Metrics Linking KPIs with Business Strategy

In most organizations, the accounting or finance group is responsible for assembling a series of reports after month-end and after the accounting close. The reports are assembled and distributed to senior managers to provide them with a clear understanding of the state of the business. An effective reporting package should include four items: an Income Statement, Variance of Actual to Plan, Production and Financial Forecast for the Balance of the Year, and a Scorecard with Key Performance Indicators (KPIs).

The first three reports in the package present economic and production information, while the last report provides metrics associated with company objectives and department-specific initiatives. As a general rule, the KPIs provide information about the organization’s success from a strategy perspective (i.e. financial, operational, and risk/compliance). The benefits of key performance indicators are that they . . .

  •  Quickly show senior management the measurable progress that has been made toward the achievement of company strategy.
  • Provide a fast way to explain variances in income statements.
  • Make it easy to link departmental contributions to strategy attainment, which aids in performance measurement and management.
  • Allow nonfinancial individuals to understand the organization’s success at achieving goals and strategies by tracking how the KPIs change over time.

Aligning KPIs with Strategy

KPIs should be part of every department’s initiatives and be closely aligned with the company’s annual business plan. When the business plan is produced, supporting strategies must be formulated, vetted, and approved among the senior managers.

At the department level, initiatives must then be developed that foster the attainment of the company’s overall business strategy. In turn, KPIs are established to measure the success of the initiatives.

Common strategies with corresponding key performance indicators include the following:

Strategies, Initiatives, and KPIs

Company Strategy Department Initiative Key Performance Indicator
Increase Employee Satisfaction CompanywideHuman ResourcesHuman Resources % Respondents Satisfied or Extremely Satisfied from Employee SurveysHeadcountEmployee Attrition
Increase Customer Satisfaction Companywide % Respondents Satisfied or Extremely Satisfied from Customer Surveys
Increase Profit Margin Sales Profit/Units Sold
Improve Credit Quality Sales Ensure Client Credit Files contain all executed documents and background checks
Reduce Seriously Delinquent Account Receivables Sales 90 Day + AR/Total AR
Execute Targeted Marketing Campaigns Marketing # of ProgramsReturn on Marketing Investment %
Contain and Control Costs Operations Personnel Expense/Units SoldNon-Personnel Expenses/Units Sold
Improve Vendor Compliance Compliance Vendor CostsVendor adherence to Service Level Agreements (SLA)

The strategies presented here are basic and need to be adjusted based on each organization’s specific business model. Also, if the product or service sold includes multiple steps, it is appropriate to include KPIs for each step; the key performance metrics can take the form of values and/or ratios.

Controllers can play a valuable role in establishing KPIs across the organization and helping management at all levels to ensure that strategies will attain the desired financial results, in support of the company’s business goals (growth and profitability).

To develop a KPI scorecard, take the following steps:

  1.  Identify a dozen or so important activities the team can accomplish that will contribute to the strategic objectives or compliance obligations of the business.
  2. Group the variables in a logical order, such as Production, Operations/fulfillment, Post-purchase Customer Care, Audit, and Compliance.
  3. Set targets and tolerance ranges.
  4. Benchmark against your top competitors and add benchmarks for each KPI on your scorecard. This will help in tracking how you are performing vs. the desired performance level.

Once established, the KPIs can be presented to senior managers during regular financial reporting for their review. The KPI report should always include an explanation of why you fell short of, or exceeded, the targeted KPIs. After a few months you will be able to see how the company is trending.

A Few Caveats

Be careful about creating KPIs that, if maximized, could cause problems in another area. As soon as you place a number on a table and publish it, the responsible individuals will do all they can to improve the value and reach the target that is set.

For example, time to complete a process has a very large impact on customer satisfaction. Intuitively, shortening the time element will have a positive impact on satisfaction, except when quality is reduced. If you are going to track time, you should also track error rates or rework required. If time declines and rework also declines or at least stays the same, then you’re on the right track.

Another issue that can occur is when financial people hide behind the metrics. When asked a question, a person responds with the metric, which is appropriate at first. However, especially with ratios, you must understand the ingredients of the ratio.

For example, if a KPI is “90 Day + AR/Total AR” and if the ratio declined (a good factor), did 90 Day Collections improve (which is what you want) or did Total AR increase (which is what you do not want)? Do not just look to the ratio without understanding the significance of the numerator and denominator that generated the metric. There is no replacement for understanding the numbers cold.

I wrote this post for the Institute of Finance Management “Controller’s Report Member Briefing.”  It was published in the June 2015 edition.

Author: Regis Quirin
Visit Regis's Website - Email Regis
Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.

Growth through Mergers and Acquisitions

Companies seek growth through mergers and acquisitions to satisfy one or more of the following – adding a related product or service; expanding geographic reach; purchasing assets, i.e. real estate, patent, brand; and/or, acquiring clients.  There is also the promise of cost reductions through consolidation of back-office and front-office services.  The justification for two companies coming together to either expand or further strengthen a competitive position is logical and easy to support from a financial perspective.  More than likely if an increase in shareholder value can be demonstrated, based on a proforma, the entities will proceed.

Very soon after a decision to merge or acquire is made, a press release is issued which identifies the combination benefits.  “We look forward to working with Cerberus to maintain and grow GMAC’s traditional strong performance and contribution to the GM family,” said GM Chairman and Chief Executive Officer Rick Wagoner.  “This agreement is another important milestone in the turnaround of General Motors. It creates a stronger GMAC while preserving the mutually beneficial relationship between GM and GMAC. At the same time, it provides significant liquidity to support our North American turnaround plan, finance future GM growth initiatives, strengthen our balance sheet and fund other corporate priorities.” (Ally Financial Inc.  Press Release: 2006)

But regardless of how good the merger or acquisition looks on paper, there is a large body of research that shows that mergers and acquisitions add no value, for a majority of the transactions.  In my career I have been exposed to seven entity combinations.  In two instances, the entity I was associated with was acquired; in three situations we were the acquirer; in one situation my entity assumed a majority interest in another entity; and finally one situation where a majority interest was taken in the entity where I was associated (quote above).

The successful execution of this type of growth initiative rests on the details of how the process is managed.  If you choose to acquire or agree to be acquired, consider the following three topics –

Business Integration

Systems – Integration of systems must be addressed upfront to ensure clients of each heritage entity can communicate with the new entity, in a seamless fashion, securely.  This initiative is extremely important during this period where cybercrime and hacking are ubiquitous.  Allowing systems from legacy companies to communicate via workarounds is not a secure approach.

Policy & Procedures – While these guidelines may have common features from company to company, they are custom to each organization.  More than likely your P&P does not match the P&P of the entity that you are acquiring.  You will find that one set is more restrictive than the other.  The question you will have to deal with – “Which policies should be the policies of the new organization?”

Costs – A primary reason to merge or acquire is the perception that cost efficiency can be obtained either from economies of scale, usage of excess capacity, co-location, supplier discounts…

The integration topic has a direct link to time, i.e. how fast you can integrate to secure systems, ensure consistent policies and procedures and cut costs.  Moving too quickly can cause needless disruption to the business; while moving too slowly just delays the benefit of the acquisition.

Employees

Attrition – The combination of two entities immediately creates redundancy.  Employee loss will be high. Some of this loss will be welcomed, but other will not.  You may find that you prefer Manager #1 over Manager #2, but Manager #1 resigns.  Regardless of the amount of analysis and preparation, management has the least control over the individual preferences and decisions of employees.  This point is apparent when you consider the following citation – “Yahoo has naturally lost some of its acquired talent. At least 16, or roughly one-fifth, of the more than 70 startup founders and startup CEOs who joined Yahoo through an acquisition during Ms. Mayer’s tenure have left the company.”  “Yahoo’s Other Challenge: Retaining Acquired Talent.”  Wall Street Journal Online.  Wall Street Journal, 1 May 2015.

Reporting – In my first merger experience, my company was acquired by a company of equal size but stronger economically. A colleague at the time explained to me that when two companies come together, the acquiring company assumes the management responsibility of all roles.  In essence, I would fall under that manager and be performing the role of the person that reported to me.  Every individual in the company that was acquired must be ready to do the job of their direct report.  This explanation was true for all combinations.  At times I had the higher role, as I was with the acquiring entity; while in other situations the reverse was true.

Clients

Attrition – Client loss will be high, more commonly from those clients that were associated with the brand that no longer exists.  This set of clients, do not feel they have any relationship with the new entity.  Consider short-term pricing discounts to persuade clients to consider keeping their business with the new entity.

Sales Management – If you sell a product or service in a geography and you acquire an entity in the same market, you will need to wrestle with the question of who owns the customer, i.e. territory management.  This situation occurs commonly when clients represent national accounts.

Sales Compensation – Similar to Policies and Procedures – While these compensation structures may have common features from company to company, they are custom to each organization.  More than likely your compensation plan does not match the compensation plan of the entity that you are acquiring.  You will find that one set is richer than the other.  The question you will have to deal with – “Which compensation structure should be the structure of the new organization?”

In summary, when an entity wishes to add a product or service or expand geographic reach or purchase assets or purchase clients, the acquisitions approach is considered preferable by many, as it is faster.   Just remember that the economics of the new entity will not be the economics of the addition of each heritage company.  A merger or acquisition takes careful planning to be effective.  There will be upfront costs required for integration and client incentives.  It will require flawless execution to come anywhere close to the proforma goals established at the outset.  There are too many unknowns, internally and externally, to be positive of the outcome.

Author: Regis Quirin
Visit Regis's Website - Email Regis
Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.

Pricing Strategy – Tips and Caveats for Discount Pricing

Discounts have their place, but more often than not, they are used incorrectly. Prior to offering a discount, controllers involved with establishing pricing strategy need to take the following steps:

Understand your business economics. If you have a 15 percent profit margin and for a period of time you are willing to give up a third of the margin to offer a discount, that may be a correct business decision. However, if you have a 15 percent margin, and for a period of time you give up an amount equal to 150 percent of the margin to offer a discount, that approach will hurt your business.

Establish the discount duration. Discounts should have a finite life. If they continue into perpetuity, you are just resetting price with the word “discount.” A discount is simply a marketing tool—a program that is planned, fielded, and completed. At a certain point, once the program ends, it is important to calculate the return on marketing investment received to understand whether the expense was worthwhile.

Understand the client’s needs. Some clients are driven by the word “discount.” In this situation, you should find the price that allows you to achieve your required returns, and increase the price of the product/service by the discount you will be giving. Billing and applying the discount will result in the attainment of your profit requirements. This approach is quite common in all businesses.

Different Types of Discounts

There are three types of discounts that work, as they benefit each party in the transaction. These are:

Discount to try your product or service. For a service, this includes discount pricing while the service provider gains the required knowledge to provide the client with the maximum service possible. During the early days of a relationship, a client should not be asked to pay full price, while you learn their business. For products, a discount provides an incentive for consumers to try your product vs. staying with their usual selection.

Discounts provided to clients based on their purchase volume, i.e., relationship pricing. The philosophy behind this type of discount is as follows: “If I can count on you to purchase 10 units of my product or service, I will charge you full price. But as you purchase more, I can take advantage of economies of scales, which I can pass down to you.”

Discounts provided for early payments. To incentivize early payment, it is common to offer a benefit (discount) to consumers.  Receipt of your money sooner rather than later is worth the customary 2 to 3% in discount.  But if your profit margins are already razor thin simply raise the price by the discount amount.  Billing and applying the discount will result in the attainment of your profit requirements.

Whichever type of discount is used, the greatest responsibility of the manufacturer/service provider is to communicate the discount terms and when they will expire. In fact, over-communicate these items. If you implement a discount to benefit the client but the discount goes away prior to when the customer was expecting it to go away, the relationship will be disrupted.  The discount expense will be a waste.

Avoid Three Common Discounting Errors

Controllers also need to be aware of the following three common errors when offering discount pricing:

Offering a discount to customers to entice them to pay their late bills. The message you relay here is, “Do not pay on time and I will reduce your price.”

Offering a discount to match the competitor’s price. This approach assumes your economics are the same as those of your competitor. That assumption is often very wrong. For example the competitor may be giving up a piece of their margin, while you may be giving up your entire margin.

Offering a discount on one product or set and losing money, expecting to make it up in other products/services. In some situations, one product is heavily discounted while other products are premium priced. The goal is to lose money on a few items in order to entice the client to also buy others, while making a higher margin on those other products/services. However, this approach will always backfire when you work with clients who understand the market price. They will understand where to focus their purchasing, i.e. only on the lower priced products.

The Bottom Line

A business will not thrive when it competes on price. Ensure that your value proposition is strong. Customers should seek out your company because the value you provide exceeds the cost of doing business with you.

When considering discounts as part of pricing strategy, controllers would be wise to take the following steps:

– Always calculate the projected cost of the discount to the company, prior to implementing.

– Consider a key performance indicator that measures discount usage and report on it.

– Ensure that discounted sales are booked separately from non-discounted sales, so discount usage is clearly quantifiable.

I wrote this post for the Institute of Finance Management “Controller’s Report Member Briefing.”  It was published in the May 2015 edition.

Author: Regis Quirin
Visit Regis's Website - Email Regis
Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.

Growing through Productivity Increases

Productivity is an economic concept that is discussed in the press quite often.  Growing through productivity increases occurs when the quantity of inputs declines, to produce a measure of output.  The sub-set that is referred to is labor productivity, i.e. the amount of labor required to produce a measure of output.  The importance of the statistic is based on its relationship to growth.  If productivity increases, so does economic growth, to some extent.

When an individual states that they are going to become more productive, it usually relates to a desire to increase their organizational habits and improve their time management.  Essentially they are looking to increase their efficiency (inputs), to do a better job (output).  The result is a benefit associated with time saved.

At the company level, when productivity improves, fewer resources are being used to produce the output.  Fewer resources equates to lower production costs, which translates to excess funds in the form of profits, for reinvestment into the business or distribution to investors.  Following are strategies companies employ to increase productivity.

Automation – For a manufacturer this relates to purchasing a machine to make better widgets faster.  However for a service this improvement relates to the efficient storage of information that can be shared and accessed by any department in the organization.  This information will be used for order fulfillment or reporting.  This approach can be costly and time consuming.  If you wish to utilize this strategy, please review “Tips to Mitigate Technology Implementation Challenges.”

Process Improvement – Most processes work best when there is consistency.  Variations in activities and manual processes create a higher probability of error and expose the organization to unnecessary risks and time wasting.  The task of mapping out processes and documenting policies and procedures makes you critically look at the process and identify how things may be accomplished more efficiently, i.e. understand bottlenecks, remove inefficiencies, remove bureaucracy.  If you wish to utilize this strategy, please review “Process Improvement to Eliminate/Contain Non-Value Added Costs in the Services Industry.”

Business Management – As the business grows, so does the complexity of the business. More decisions require more analysis. There are increasing fixed and variable cost considerations and cash flow becomes more important to understand and manage.  Success begins with Strategy and Planning; and subsequently ongoing measuring and reporting.  When Accounting Management, Financial Management; and Risk Management are all optimized and running efficiently; business development can be performed without reservation.  If you wish to utilize this strategy, please review “The Frequency of Best Practices with Small and Medium-Sized Businesses.

The previously mentioned strategies of Automation, Process Improvement and Business Management have historically been the drivers of productivity increases.  But I predict that in the next five years, two additional strategies will emerge as drivers of productivity increases.

Labor Support and Development – High labor turnover is wasteful to any business.  Filling an open position is costly – posting a job; interviewing candidates; hiring an individual; and training the individual.  Once you obtain the right employee, a business should do as much as possible to keep the employee.  A business should invest in an employee, as long as the value received from the employee exceeds the investment by the company in that employee.  Some ways organizations invest in their employees include – providing financial support for job related training; considering non-standard work arrangements; ensuring compensation is at the market rate; and supporting retirement and health care benefits.  From the time the Great Recession began in December 2007, until it officially ended in June 2009, employees continually lost benefits including training and retirement benefits.  Companies that return to pre-recession benefits will experience a jump in morale, sooner than competitors.    For an example of how to utilize this strategy, please review “The Value Embedded in Tele-Commuting.”

A recent example of the support to labor includes – “Blackstone Group LP said Wednesday that it is extending its maternity leave benefits from 12 weeks at full pay to 16 weeks. The move, announced in a memo to employees, is designed in part to help the company compete for talented Wall Street women.”  Lauren Weber and Ryan Dezember.  “Why Blackstone Is Giving New Moms More Time Off” Wall Street Journal Online.  The Wall Street Journal, 22 April 2015.

Data Management – The ability to read data, i.e. Big Data, to understand how to best allocate company resources efficiently, should be a large driver of productivity in the future.  The firm combines price, product, place and promotion in the hope of finding the appropriate relationship to appeal to the target market.  The degree at which these variables are manipulated is based on available data, i.e. geographic assumptions and customer qualities within the geography.   As reported in Game changers: Five opportunities for US growth and renewal a McKinsey Global Institute study (July 2013), “Amazon has taken cross-selling to a new level with sophisticated predictive algorithms that prompt customers with recommendations for related products, services, bundled promotions, and even dynamic pricing; its recommendation engine reportedly drives 30 percent of sales.  But most retailers are still in the earliest stages of implementing these technologies and have achieved best-in-class performance only in narrow functions, such as merchandising or promotions.” (page 75)

In conclusion, firms focused on improving productivity should consider implementing Automation, Process Improvement and Business Management enhancements, as these are proven strategies; as well as additionally incorporating newer opportunities in the areas of Labor Support and Development and Data Management techniques.

Author: Regis Quirin
Visit Regis's Website - Email Regis
Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.

Business Disruption Survival Techniques

Establishing a twelve month budget/business planand a business continuity plan are still the best ways to prepare a business for the most probable known threats. But what can you do for unanticipated shocks that negatively affect your ability to achieve your profit goals? When companies are faced with unanticipated situations, that threaten their business, and they realize these disruptions are not short-term issues, they may need to employ “business disruption survival techniques.”

Examples of situations that few saw coming include – The sudden drop in the per barrel price of oil, i.e. NYMEX closing price $99.75 (6/30/2014) vs. $52.78 (02/13/2015), negatively impacting oil and gas companies, and the businesses that support them. Union disagreements and work stoppages at US ports along the West Coast, negatively impacting the inventory of many businesses that sell imported goods. This situation is believed to be resolved, after nine months. The climb in the value of the dollar against most currencies, resulting in exports becoming more expensive, while imports become cheaper.

In reacting to these shocks, businesses implement three main types of cuts, for the sake of temporary relief, i.e. expense personnel, expense non-personnel and investments. If not done correctly, these approaches may do more long-term harm, than good. Activities are as follows –

Slash budgets (Personnel Expenses) – As personnel expenses are the largest cost associated with every business, targeting this expense is usually the first move. This tactic includes implementing hiring freezes and job eliminations.

Additional approaches include salary freezes; bonus reductions; and reducing or eliminating the company investment in the employee, i.e. usually related to education subsidies. More often than not these approaches will leave you with a large exodus from among the high performing dis-satisfied employees that can move to your competitors.

A popular technique which I believe is a big mistake is to provide a stay bonus to a select few. The message relayed with this last strategy, “If you did not receive a bonus, you are not considered critical to the organization.”

Slash budgets (Non-Personnel Expenses) – In the short-run, fixed expenses cannot be slashed, i.e. rent, insurance… The target of this tactic is usually variable expenses, i.e. marketing. But during this time of a disruption, marketing is very important to bring in new sources of revenues.

Delay Investments (Revenues) – To preserve cash during tough times, companies may place a hold on investments until the difficulties pass. But why would you wish to delay the opportunity for revenues, associated with a new product or service?

To avoid the slash and burn mentality, establish an environment of constant review and analysis. Do not wait until you are forced to make a large correction. Make small adjustments to your business, continually along the way. Suggested areas to monitor include –

Review Client Arrangements – Obtaining a customer that becomes unprofitable is a common situation. It only becomes an error of management if you do not constantly review the situation to understand the returns.

Review Products or Services – Periodically every business should review its product lines and services, to understand the profitability generated. The natural result will be an emphasis on the most profitable activities; while de-emphasizing the less profitable or money loosing activities.

Review Accounts Receivables – If you extend credit to your customers, which is required for almost all businesses, a certain amount of bad debt will result. At a certain point, you will need to ask for what you are owed. Resolving this bad debt efficiently and quickly, while not disrupting the possibility of future business from the customer takes tact and experience.

Understand Variable Expenses – Review your needs – Contracts represent your needs at a point in time, i.e. when they were executed. It makes sense that a contract will include items you no longer need – understand needs; understand pricing alternatives; seek opportunities to bundle; and avoid the warranty trap with new technology.

Consider Business Management Practices – The solution to counter an underperforming small or medium-sized business is a redesign. Interestingly, the method to redesign a business is the implementation of standard business management “best practices.”

Continue to Review Investment Opportunities – A company should only allocate cash to the most profitable uses, with the highest return on investment, which will provide potential distributable benefits to its investors, within the shortest amount of time.

Survival will be based on your ability to shift quickly, but strategically.

You can never plan for external disruptions, but you can prepare. Do the analysis today.

Author: Regis Quirin
Visit Regis's Website - Email Regis
Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.

Who Owns the Customer, i.e. the Company or the Sales Agent?

This question was less important when the job market was in decline.  But as the economy recovers, business owners and senior managers will be faced with this question, more and more.

Depending on who you ask, there are two popular, but contradicting opinions.  If you ask the owner/CEO of the entity – “The customer belongs to the company.  They come to us because of our quality products/services.  The Sales Agent has been properly compensated for procuring the customer on our behalf.”

However, If you ask the Sales Agent – “The customer belongs to me.  They were sourced by my efforts and we have a relationship.  They transact business with the entity because of me.”

In fact, it is not uncommon for a Sales Agent to maintain a separate and personal file of their interaction with the client/customer.  When they leave your entity and seek employment from your competitor, they may say, “I produced $XXX in revenues for my last company, and I can do the same for you.  I maintain a book of business that will more than likely follow me, if I move to your company.”

There is a legal answer to this question, which I was reminded of, when I left an entity after fourteen years, even though not in a Sales capacity.  Not more than 30 days after my departure from one entity to a competitor, I received a letter from the President of my former employer.  Excerpts of the note are as follows -“In view of your departure from XYZ, this letter is to remind you of your obligations to XYZ, and under the law, both during and after your employment with XYZ…it is your obligation to handle XYZ trade secrets, confidential or proprietary information to which you had access during your employment at XYZ, whether in your memory or in writing, or in any other form, with the strictest confidence and in a manner consistent with XYZ’s policy, both during and subsequent to your employment…you may not misappropriate or use for the benefit of anyone other than XYZ any confidential or proprietary information relating to XYZ’s business.”

So what can you do?

As a first step, make sure your compensation agreements and employee agreements include language that clearly states the client belongs to the company and the legal obligation of the employee.  This agreement should be reviewed and approved by a qualified Labor Attorney.

But even after this measure, you may find that the client leaves you and follows the Sales Agent.  This situation may occur not because of what the Sales Agent did, but more because of what you did not do.  The companies that lock in the client and foster brand loyalty have developed a communication link with the client.  If you do not reach out and establish this link to your brand, the only connection the client has to the company is the Sales Agent.  More than likely, if the Sales Agent leaves, so will the client.

Popular approaches companies use to reach out to the client and maintain contact include offering post purchase support or discounts on future purchases or advertising related products/services.

At every possible opportunity your entity should advertise the brand and state the value proposition.   Regardless of the product/service, every business runs the risk that what they offer becomes a commodity in clients’ minds, i.e. belief that every competitor offers identical product/service.  If all products/services are the same, why not just work with the individual Sales Agent, wherever they go?

But your value proposition is your differentiator.  Customers/clients will seek you out and be less sensitive to price if they understand the benefit of working with you vs. other vendors.  How do you differentiate yourself from the pack?

It is a valuable exercise to identify and document what makes you different.  The results of this activity should become the basis of all marketing materials, i.e. your value proposition.

An example of a value proposition that I have used includes the following commitments.  XYZ Entity –

  • Offers superior product or service;
  • Makes an effort to understand your specific needs and has many ways of doing things so you can find the one that meets your needs;
  • Takes responsibility to get things done;
  • Is knowledgeable about the product/service you seek;
  • Tells you what you need to know in the way you understand;
  • Offers a complete array of the product/service you seek, to make your life easier.

The only way to maintain a client is to develop a relationship between the client and the company, through consistent messaging that differentiates yourself from the pack of competitors.

Author: Regis Quirin
Visit Regis's Website - Email Regis
Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.

COSO Internal Control—Integrated Framework 1992 vs. 2013

By December 31st 2014, companies that utilize the 1992 COSO Internal Control—Integrated Framework are expected to have fully transitioned to the 2013 framework.  If you are an organization that is required to report to the Securities and Exchange Commission, this change directly impacts you.  But when you look at what the framework represents, it is obvious that both public and private organizations of all sizes could benefit from adopting elements.  The purpose of the framework is to prevent and detect fraud.  It is a standard framework for designing, implementing, and conducting internal controls; as well as assessing the effectiveness of your current internal controls.

The standard was updated to account for the ongoing changes in the business environment, i.e. evolving technology, increased outsourcing, changing regulatory environment…  The most significant change in the 2013 framework from the 1992 framework was the addition of 17 principles and 77 focus areas.  These new items further define the five core areas – Control Environment, Risk Assessment, Control Activities, Information & Communication, and Monitoring Activities.

 COSO 17 Principles

Elements that would be most applicable to small and medium sized entities include –

  • Control Environment – The entity demonstrates a commitment to integrity and ethical values. Senior Management is responsible to designate the individual(s) responsible to manage the satisfaction of reaching the entity’s internal control objectives; as well as continually developing the individual(s).

 

  • Risk Assessment –The entity sets its internal control objectives; as well as operations and financial goals. Externally the entity abides by frameworks, laws and regulations.  Internally, risks are identified and their significance established.  Approaches to respond to the risks are established.  Fraud and all the potential ways it can be committed are considered.

 

  • Control Activities – The entity develops control activities, which include segregation of duties, technology control activities, and policies and procedures.

 

  • Information & Communication – Obtain and generate information. Communicate this information internally and externally.

 

  • Monitoring Activity – On an ongoing basis, evaluate internal controls to understand their presence and effectiveness.

 

So how do you start?

Review the COSO Internal Control—Integrated Framework (Core areas, principles, and focus areas) to understand what elements apply to your situation; conduct an assessment of your organization, seek board/management approval on concept implementation, engage staff through training and communications, develop a transition plan, execute the plan, monitor success and adjust if required.

If you are looking to establish internal controls for the first time, it may make sense to bring in a third party that understands your industry and the common risks, which should be considered.  Team this individual up with an internal resource that understands your entity and your processes.

Additional posts on this subject include –

What is the proper way to roll-out an ethics program?

 Internal Audits – “Inspect what you Expect”

 The Best Way to Avoid Fraud is to Remove the Opportunity

 How Problematic is a Financial Restatement?

Update – WSJ (04/29/2015), “Almost three-fourths of the U.S. stock-listed companies that have filed 10Ks with the U.S. Securities and Exchange Commission since Dec. 15, 2014 have transitioned to using the updated COSO 2013 framework for reporting internal controls of their financial reporting requirements, said Bob Hirth, chairman of the Committee of Sponsoring Organizations of the Treadway Commission (COSO Commission).”

Where are you in the process?

Author: Regis Quirin
Visit Regis's Website - Email Regis
Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.