This is the last in my series of commentaries on recurring revenue. In my previous commentaries, I discussed how recurring revenues, long-term contracts, and counter-cyclical services can help smooth out your business’ cash flows – all of which focused on steps you can take to improve, smooth or extend sales/revenue generation.
In this final commentary, I am going to focus on the other part of your Profit & Loss (P&L) statement and managing your business’ costs and expenses to help smooth out the inevitable dips in the road.
To start, let’s distinguish the important difference between variable and fixed costs:
Variable vs. Fixed
In most businesses, there are two kinds of costs or expenses:
Variable – those that move up and down with sales (typically your cost of goods sold or cost of sales items), and
Fixed – those that do not change as your sales fluctuate (typically your business overhead items and many of the items that appear under the “Expenses” heading on your P&L)
The Good
When it comes to your business making its way through difficulty (of whatever kind), the good news is that in a well-managed business variable costs should move up and down along with sales.
Practically, what that means is that a business should not fail because it had to buy too much copper or PVC piping during a downturn. Those costs should automatically rise and fall in proportion to any decline in sales (absent changes in inventory). In fact, it’s more likely that a business gets into trouble with pipe costs when it’s growing rapidly (and getting paid slowly) than when sales volume is declining.
So, generally, a business’ variable costs (e.g. Cost of Goods Sold) should be self-correcting in a declining sales situation. Again, from a managerial perspective, that’s good news for you because in many cases you shouldn’t have to “do” much to address these costs.
The Bad
On the flip side of the equation, the bad news is that your mortgage, rent, debt obligations, and many staffing expenses don’t typically “self-correct” in the event of a sales decline.
And, as owner/manager of your business, you probably know not being able to do anything about a significant level of fixed expenses can be a major problem and even result in failure when sales volume recedes.
How to Keep It from Getting Ugly
Managing your fixed expenses can get especially ugly if you don’t have a good plan for managing them in a sales decline. Your staff members generally won’t want or volunteer to take a pay cut. Likewise, your creditors aren’t fond of taking pay cuts – and may seize your business or business assets if you don’t pay them. And your office could go dark, cold or dry if you don’t pay your bills on time.
There is no way to assure yourself your business will never experience a financial pinch. But the following are, in my view and experience, some of the best managerial steps you can take to avoid the ugliness noted above that could arise in major cutback, bankruptcy or liquidation situation:
- Run a lean operation by avoiding unnecessary costs. Examples would include things like unneeded or excessively-expensive office space, staff, vehicles and other assets.
- Build and maintain a cash buffer for your business – at all times. A good safe harbor for individuals is 3-6 months of cash expenses… many small businesses – especially seasonal and cyclical ones – would do well to have that much or more cash reserves.
- Be resistant to add permanent full-time staffers in fluctuating need roles. If your business volume regularly ebbs and flows, considering using temporary, seasonal or part-time help in roles where that’s possible.
- Make a portion of every employee’s compensation a profit-based bonus (vs. level pay), particularly for non-production and non-hourly staff members. That way if business activity drops… you have an automatic, fair, and across-the-board method for adjusting company payroll. Inform staff at their hire to expect variable or even no bonus pay, and regularly remind them that their bonus depends on business performance.
- Own/lease as few vehicles as possible for the business. When possible, help crew members or traveling salespeople to buy/lease their own vehicle and reimburse them by miles driven, or some other metric that various in proportion to business sales volume.
- Have a line of credit (LOC). And avoid maxing it out in “good times.” Try to have a max available LOC that is well above the max. temporary borrowings you may draw from it to cover seasonal or short term irregularities in business cash flow.
- Live 20-30% below your means (normal draw or pay level) as owner. Have cars and a home that you could afford with a 30% drop in your draw or pay. Build and maintain personal savings.
The common theme of these tips is that they will make your business costs and ability to deal with them more flexible – which could be a great help in running your business in the case of a problem or downturn.
Should you need help implementing these tips or identifying opportunities to make your business or cost structure more flexible, we encourage you to contact us here.
Long live small business! Long live small business owners!
Jim Smith, CFP, Founder, PERFORMIDABLE, LLC