Controlling The Cost-lag Loop
As the economy prepares to make its periodic trip south, astute managers are already taking stock of their businesses, figuring out what they can do now to keep their companies healthy when the ill winds of recession start to blow. That they will eventually start blowing, there can be no doubt -- current forecasts notwithstanding. And it is equally certain that managers will be better prepared for the stormy season if they have first mastered the mysteries of the cost-lag loop.
The cost-lag loop is the path taken by actual costs on a break-even chart as volume rises and falls during economic cycles. In an ideal world, it would not exist. That's because the loop is caused by a failure of management -- specifically, the failure to keep changes in costs approximately in line with changes in the volume of sales.
In thinking about how to deal with the lag problem, it helps to look at an actual graph. At the risk of oversimplifying, let's begin with the traditional break-even chart, illustrated in Figure 1. As we all know, such a chart is based on the notion that companies have two easily distinguishable types of costs: "variable costs," which change with sales volume, and "fixed costs," which change over time and by management decision. The sum of the two equals total costs, and determines a company's profit or loss, depending on where its sales stand in relation to the break-even point. Simple, right? In theory, managers can protect their profits just by making sure that sales remain above a certain level, namely, the level at which total sales equal total costs.
Would that the world were so neat.
In reality, of course, a company's costs seldom behave as they are supposed to. Fixed costs have a nasty habit of becoming unfixed on the upside, while variable costs turn out to be not so variable on the downside. As a result, total costs almost always rise a lot more easily than they fall, producing a cost "lag" when sales volume declines. If you were to chart this process over the course of a company's economic cycle, you would, in most cases, wind up with a cost-lag loop, much like the one shown in Figure 2.
Most companies go through six distinct phases in such a cycle, all of which are indicated in the chart on the right:
* Phase 1 is the profitable-control phase, during which volume is rising steadily and, with it, total costs, in roughly the same proportion. This is the phase that most nearly resembles the ideal performance of the traditional break-even chart.
* Phase 2 is the saturation phase, when increasing volume has led to a disproportionate increase in costs. The higher volume has created inventory stock-outs, raising expediting charges and causing an increase in the quantity of goods ordered. Expanding inventory forces the company to add warehouses, which soon overflow. Inventory control measures fail, having been designed for smaller inventory. As a consequence, stock-outs continue even as excess inventory grows. Less efficient equipment and newly hired employees are pressed into service, further raising costs. Overtime premiums also have skyrocketed. Meanwhile, overhead costs -- from manufacturing to accounting to the executive suite -- have risen as well.
* Phase 3 is the spending-momentum phase. Sales have started to decline, but spending has gained momentum from the previous phase and continues to increase. New employees, hired to perform new jobs, continue to spend as they always have. New goods and services, ordered during the good times, continue to be delivered and billed. New capacity, contracted during Phase 2, comes on line now that it isn't needed, raising both operating costs and interest charges. Inventory, bloated with obsolete and excess material, is scrapped and liquidated at a loss, to reduce warehousing costs.
* Phase 4 is the unprofitable-control phase. The excesses of Phase 3 have caused management to tighten the corporate belt. Some fixed the variable costs have been reduced, but not to the level of Phase 1. Again, costs rise and fall in proportion to the change in volume; but profits have fallen drastically, or disappeared entirely. The major difference between Phase 1 and Phase 4 is that overhead once considered a luxury has now become a necessity.
* Phase 5 is the desperation-cut phase. As volume continues to decline, management begins to realize how inadequate previous cost-cutting efforts have been. Competitors that have controlled their costs to the Phase 1 level now use those lower costs as a weapon in the fight to capture market share. Lenders and investors, who have reluctantly supported the company during the downturn, express their concerns more strongly as losses mount. In an atmosphere of desperation, necessities become luxuries; "fixed costs" become unfixed; and management slashes spending.
* Phase 6 is the savings-momentum phase. Those employees who survive the desperation cuts suddenly realize that management is serious about saving money. At all levels, they find new ways to cut costs. Hourly workers volunteer cost-saving suggestions. Middle-level managers reexamine their make-or-buy decisions, renegotiate vendor contracts, liquidate unused assets, and take other steps to bring additional savings. With enough encouragement from management, the attitude of frugality can continue well into the next upturn.
That is a more or less typical cycle for a company, but it is not necessarily an inevitable one. "Lag, in general, is the tangible evidence of management inability to keep abreast of the demands for action when output is falling," as Fred V. Gardner of Northwestern University wrote in his classic (but out of print) Profit Management and Control (1955). Stated another way, managers have the power to control and narrow the loop, and thereby protect profits. In that case, the loop would wind up looking more or less like the one in Figure 3. To pull this off, however, you must be aware of the dangers, committed to avoiding them, and willing to take action at critical stages, particularly in Phases 2 and 3.
During the heady growth of Phase 2, customers, employees, and investors can put tremendous pressure on you to increase the number of products, cut delivery times, expand capacity, and generally take full advantage of every opportunity that a booming economy offers. You must remember that no economic trend lasts. In time, many customers will disappear; employees will lose their enthusiasm; and investors will start complaining about overexpansion.
Since the trend won't last, try to make decisions in Phase 2 that can be reversed when the bubble bursts. Rent rather than lease; lease rather than buy; buy with a plan to sell. Rather than adding new capacity, use subcontractors, or drop marginal product lines to free up existing capacity. Rather than committing to long-term purchase contracts, make short-term agreements or negotiate low cancellation charges for long-term ones. Rather than working to build inventory, focus on reducing inventory, going through your product line and eliminating those slow-moving items that will stop moving entirely when the market cools down.
At the beginning of Phase 3, your business will start to slacken. That's the time to reexamine your own attitudes. In the past, a booming economy and falling interest rates have allowed many problems to resolve themselves. Hard work and risk-taking have brought you success. But will it last? Not if you fall victim to a complacent, and unfounded, optimism that everything is just going to keep on working out for the best. That attitude can lead only to indecision and inaction at a time when action is desperately needed.
As the economy heads into recession, your primary task is to enlist every member of your organization in the cause of controlling the cost-lag loop. All purchase orders and shop orders must be reviewed in light of the expected retrenchment, while change orders and cancellation orders must be issued as necessary. Since your customers may be taking similar actions, bear in mind that your order backlog may be in danger as well. Hiring should be frozen, overtime slashed, budgets redone (perhaps guided by actual spending during Phase 1), and priorities should be redefined.
These efforts, if successful, may yield an unexpected benefit, namely, a temporary increase in cash. That's because collections continue at their old rate for a time, while spending for overhead and inventory declines. Use this extra cash wisely; it may be the last that you'll see for a while.
I don't mean to make any of this sound easy. Retrenchment can be an arduous process. So, for that matter, are most other aspects of controlling the cost-lag loop. If you do your job well, however, you will save your company a lot of grief over the long haul. In fact, you just might save your company.