Cash and Profits Are Not Interchangeable

The Merriam-Webster dictionary defines profit as “a valuable return” which would imply there is actually something being received at some point in the process.  However, the reality is that you cannot actually “spend” profits. You must have sufficient cash available to fund the company’s operations until conversion occurs.  Since there is nothing tangible returned by profit alone, the logical conclusion is that without cash conversion there is no REAL profit: CASH IS THE LIFEBLOOD OF EVERY ORGANIZATION. Generating it is the most important aspect of profit management and conversion of profit into cash in the shortest possible time frame should be a goal of every organization.

Back to Basics: Breakeven Point

The breakeven point is the volume in dollars of revenue at which revenue and expense are equal (there is neither profit nor loss).  Any revenue above the breakeven point will provide net profits and any revenue below the breakeven point will produce losses.  The breakeven point is not static and can move from time to time depending on changes in the revenue mix and/or the company’s expense profile.  For example, if one of your fixed cost elements were to increase (let’s say rent), this would move the breakeven point to a higher revenue level.  In contrast, if the revenue mix changed to include a larger percentage of high margin component(s), the breakeven point would move to a lower revenue level.

It is very important to know at what level of revenue your company reaches its breakeven point.  An understanding of the breakeven concept will help you to quickly determine the level of action required and in which areas you should focus your attention in order to improve the financial performance of the company.  In some cases it will be revenue that must be impacted and in others the expense structure must change.  The ultimate decision will depend on the specific environment you are operating in at any given point in time.

Back to Basics: Workers Comp

Workers' compensation is a form of insurance providing wage replacement and medical benefits to employees injured in the course of employment.  Workers’ compensation insurance costs are based on a rate per $100 of payroll.  Although it is a fairly complex calculation involving a number of variables, the rate is determined primarily by your company’s type of business, the various types of job classifications present within the employee population and its experience with regard to medical expenses and replacement wages resulting from on the job injuries.  For example, in the State of Texas the rates range from a low of about $0.20 to a high of approximately $60.00 per $100 dollars of compensation that will then be adjusted for the experience modifier and other discounts or adjustments that might apply.  As you can see, the range is quite large and, depending on the company’s type of business, it can be a very expensive benefit. 

Remember that workers’ compensation is mandated by most states in the U.S.  The only effective way to manage this expense is to control the number and severity of on-the-job injuries.  Left unmanaged, this expense will drain very large amounts of cash from the operation through unnecessarily high payments for insurance premiums (penalties can be well in excess of 50% to 75% per year through the experience modifier).  To further complicate the situation, because the modifier is determined by the injury experience from a number of years, your ability to fully affect the cost is incremental over that same number of years (usually 3 to 4).  The difficulty will be in managing the timing of costs associated with changes in operating conditions (near-term) relative to the benefits derived from lower insurance premiums realized progressively over several years.  You should consult with a risk management professional to determine what can and should be done in your organization to control this exposure.  If the work environment and operational process are managed properly from the outset the risks can be mitigated, and therefore, the costs are contained.  However, if these issues are left unmanaged it will take years to recover and the relative cost to the company will be significant.

Found Money!

Deposits are recorded when an amount is required to secure a long-term arrangement for operating the business.  Examples include rent, utilities, large orders for certain special order items such as preprinted materials, uncommon equipment or unique inventory items, etc.  These accounts represent hard cash that has been placed with another party for a period of time.  A regular review should be conducted to ensure that all amounts due to be refunded are done so in a timely manner.  Remember, it is your cash and it should be managed as such!

When Is Expired Inventory Acceptable?

Some items will have a limited time in which they are useable due to a time-induced deterioration in their physical qualities.  This “shelf life” should be considered when determining the reorder process for replacement inventory.  It is fairly obvious that you would not order a six-month supply of an item that has a shelf life of 120 days (approximately four months).  This would be true even if there were certain discounts associated with the purchase volume for a particular item unless the discounts are so significant that it would not matter that a portion of the inventory would be discarded from time to time.  For example:

•          Assuming product A has a shelf life of six months and a usage rate of 62 per month.  If you had the option of placing one order of 500 for $3.20 each or multiple orders of 200 for $4.50 each as necessary, what would you do?  The total purchase price for the quantity of 500 would be $1,600.  However, at a rate of 62 per month you would actually use only 372 before the shelf life expired.  The 128 time-expired items will have to be discarded resulting in waste and then be replaced with an additional expenditure of $409.60 (assuming the same purchase price).  On the other hand, if you placed two separate orders for 200 each (three months apart) at the higher rate of $4.50 the total cost would be $1,800 without the waste associated with time expired items.  And you would still have 28 items in inventory with an additional shelf life of three months.  Would your decision be different now?  The cost of the discarded expired items is high enough to make it more economical to purchase the lower volumes at the higher unit price.

Purchase Qty	Original Purchase Price	Additional Cost  for Time Expired	Total Cost
500	$1,600.00	$409.60	$2,009.60
200 x 2	$1,800.00	$0.00	$1,800.00
Net savings in purchasing two orders of 200 items			$209.60

•          Now assume product B has a shelf life of six months and a usage rate of 75 per month.  If you had the option of placing one order of 500 for $3.20 each or multiple orders of 225 for $4.40 each as necessary, what would you do?  The total purchase price for the quantity of 500 would be $1,600.  At a rate of 75 per month you would use 450 before the shelf life expired.  The 50 time-expired items will have to be discarded resulting in waste and then be replaced with an additional expenditure of $160.  On the other hand, if you placed two separate orders for 225 each (three months apart) at the higher rate of $4.40 the total cost would be $1,980 without the waste associated with time expired items – you would have zero items left in inventory.  What would your decision be this time?  The higher usage rate reduces the number of items left to be discarded when the self life expires.  Therefore, the overall cost of discarding the 50 items relative to the purchase price is sufficiently low to justify the larger purchase quantity and allowing the remaining time expired items to be wasted.

Purchase Qty	Original Purchase Price	Additional Cost  for Time Expired	Total Cost
500	$1,600.00	$160.00	$1,760.00
225 x 2	$1,980.00	$0.00	$1,980.00
Net savings in purchasing one order of 500 items			$220.00

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Why Are You in Business?

Why are you in business?  After a quarter century interacting with hundreds of companies and observing many thousands of people, it appears to be a question that, surprisingly enough, many people do not fully appreciate.  There are nearly as many reasons given for being in business as there are people having been asked the question.  Notwithstanding the fact that many individuals employed by the same companies will often give somewhat similar answers, they are rarely exactly the same and, in a disturbing number of cases, more than a few are vastly different.

Some people say they are in business to deliver a certain product.  Another group might say they are in business to provide a unique or special service.  Many might say they are developing a breakthrough technology or the next “killer app.”  Then others would say that delivering the highest quality is the reason for being in business.  Although these are all very important aspects of running a successful business, they are NOT the reason you are in business.  A company is in business to make a profit.  It’s that simple.  There is no other higher priority, period. 

Back to Basics: Accounts Receivable

Accounts receivable is the amount of uncollected revenue for which the company is expecting to receive payment from its customers.  It represents the largest and most accessible source of non-financing cash that the company has available.  It is the last stage in the cash cycle before an item becomes cash once again.

Given that A/R is the closest to cash of all other items on the Balance Sheet, it is the most important item to manage next to cash.  There must be a concerted effort to manage A/R each and every day.  Unfortunately, experience has proven that most managers do not attempt to manage A/R with more than a passing thought until there is a problem with cash or a question arises regarding the validity of the recorded balances.  Usually, by the time a problem is recognized, the possibility of a full recovery of the cash collection potential is remote.  You must understand that the vast majority of all adjustments to A/R will have a direct impact on your bottom line and therefore your future cash flow.  An adjustment to the A/R balances will, in almost every case, result in an adjustment to revenue in one way or another.  An account that has been determined to be uncollectible will be recorded as bad debt expense and will directly reduce the company’s profit.

Mismanagement (or truly non-management) of accounts receivable has been the death of many otherwise viable companies.  Without a thorough understanding of the dynamics present in the A/R of your company you cannot be confident of any performance information produced.  With a large adjustment resulting from the fallout of an unforeseen A/R problem, any recorded profits can be completely eliminated in an instant.  Without warning, very large chunks of what was thought to be future cash flow can evaporate unexpectedly leaving the company extremely vulnerable.