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Knowing Your Economics: The Discipline of the Financial Leader

knowing your economicsMichael Gerber said it best in his book, E-Myth Mastery, “there is nothing in the creation and operation of a company that so seemingly conspires to confuse, intimidate, overwhelm, complicate, rationalize, and metastasize the plain ignorance of the average business guy, or woman, then money” (172). But why is that so? It’s because as humans, we tend to overcomplicate and twist even the simplest of things… Because it can’t be that easy! As we dig into the discipline of the financial leader and knowing your economics, let’s get on the same page. Money can mean different things to different people, but in the end, money is meaningless without people – just like business is meaningless without people.

The Discipline of the Financial Leader

Over the past 25+ years, The Strategic CFO has made it our mission to convert number crunchers into financial leaders. Anyone (relatively speaking) can account, but it takes someone specific to be a financial leader. The financial leader is simply that, someone how leads the company financially. But it’s often difficult when you have multiple leaders in the company without a focused vision or goal. Thus, Michael Gerber expands that “to the degree the enterprise leader is clear about her vision, the financial leader can build a financial model of that vision…” (174). That being said, you need to be in constant communication with your entrepreneur, CEO, and executive team. Sometimes the best conversation is where the financial leader is listening. That communication will transform you from a financial guru to a leader – where you need to be if you’re going to succeed. Knowing your economics or financial statements is just the first step to becoming a discipline financial leader.

When you discipline yourself to knowing your economics (or financials), knowing your cash position (balance sheet), knowing how every decision impacts the bottom line, you will find yourself leading the company forward. The basics are critical. Often, we find that accountants, Accounting Managers, Controllers, CFOs, etc. are only concerned about the costs. But they also need to be involved in the sales and operations of the business. There shouldn’t be a day that you as the financial leader do not think about the entire business.

A best practice that our leaders have implemented is to walk the plant, go out to the field, and spend time in the manufacturing facility. The key here is to get out of the office.  Having conversations with the field people and shop people can often lead to great ideas the financial leader can implement.

Knowing Your Economics

Again, it seems simple… Do you know your numbers? So many times when we come into a company, we find that not the CFO, CEO, COO, CMO, or anyone in leadership truly knows their numbers. The numbers we’re talking about are your unit economics. Unit economics shows your revenues with their direct costs associated with that one unit. Look at the following example for a simple unit economic breakdown:

   Revenue       $10

COGS          $3.5  

   Gross Margin  $6.5

It’s best if you can allocate each cost to a single good. While it may take some work to do that, some companies neglect to address SG&A when they look at their unit economics. That results in false economics or financial results; and eventually, you will find yourself out of cash. While the example above is really simple, it works. If you find that it doesn’t work, then you may not have a good costing system in your manufacturing facility, your margins may be off, and again, you income statement may not be accurate.

If your income statement not profitable or need to be improved, click here to download our free Know Your Economics worksheet. It walks you through how to become more profitable, starting with the basics.

Once you have accurate financial statements, the only way they will be of any value is if and only if they are completed timely.  Getting your financial statements 1 or 2 months later does no good and does not provide decision makers timely information they need.

Improves Decision-Making

Knowing your financial situation helps improve your decision-making. When you know how much you sell a product for, what its associated costs are, you know how much margin you have. If your costs go over a certain threshold, then you will be unprofitable. Knowing your unit economics is a simple test to know if a decision will be a profitable one or not.

Using the same example above: if you want to implement a new software that would automate the sales but it costs an additional $7 per unit, then you would be unprofitable. As a financial leader, express this with your sales team. If they cannot provide evidence or sales projections that increases the number of units sold (thus reducing the software cost per unit), then the decision is no.

Expands View of Business

When you know the economics, margins, and financial position of your business, you are able to see a lot more. It’s the basics of doing business – much like eating and exercising. You need it to remain healthy. Ingrain the economics of your business in your entire team. Marketing, sales, finance, operations, etc. need to know how each decision impacts the profitability of the company. When you do this, each employee is able to think more constructively. In addition, you build a culture of financial leadership. With the basics under your belt, you are able to expand your view of the business.

For example, when we bring on interns in the summer, we drill our unit economics. Then as they get further into their internship, they bring more value because they know how the business works. They may see something that we as long time employees/leaders don’t.

Weather Storms or Sunshine

Unfortunately, recessions roll around occasionally. Economic crisis is a natural cycle. Then sales start booming and you can’t fulfill those orders fast enough. Whether you are weathering storm or sunshine, it’s critical that you know the basics of your business. When you know your economics, you can shape your economics to result in profit – in storm or sunshine. If you need help shaping your economics, click here to download your free Know Your Economics guide.

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Are you throwing money at your problems?

are you throwing money at your problemsGrowing up, I constantly heard the old adage, money doesn’t grow on trees.” It’s meant to warn people that there is only a limited amount of money available to put to use. It’s easy to fall victim to the notion that any problem can be solved if you spend enough money on it.

But, what happens when you go so far down a road that you’re unable to see yourself out? Sometimes, it seems like the only option is to pay someone to guide you back where you belong.

Through personal experience, I know that this option can run you dry and ragged. Keep in mind that there are incredible consultants out there that have made major positive impacts in my company.  However, acting out of desperation can get you into some trouble if you don’t think things through.

Do you ever find yourself throwing money at your problems?

The Problem

Companies never seem to have enough cash (unless you’re Google or Apple). In addition to this cash shortage, roadblocks and problems seem to consistently pop up.

While it’s true that you have to spend money to make money, what if you find that you are continuing to spend money without seeing a comparable return? This is when we run into the problem.

Me

A few years ago, I had a big project that I was set on making a success. After a few months, my team had lost traction and we weren’t seeing any growth. Instead of doing the dirty work myself to find out what the real problem was, I hired a consulting firm to help us without vetting multiple firms.

When you find yourself in a hole, stop digging.

While trying to avoid making mistakes in troubled times, I found myself standing at the bottom of a hole.

Langley & The Smithsonian

are you throwing money at your problemsAviation started out as a hope and a dream to many. The Smithsonian Institution put forth a hefty budget in order to get recognition as the first to pilot an aircraft.

In the late 1880s through the early 1900s, Samuel Langley had been extensively researching aeronautics, hoping to be the first man to pilot an airplane. Throughout his career, he was set on progressing from flying planes un-piloted to him piloting the planes.

In 1903, the United States government, backed in part by the Smithsonian, awarded Langley a $70,000 grant to expedite his progress. That October, Langley and his team launched the first “heavier-than-air” aircraft with a pilot in the cockpit. There was so much excitement as many stood to witness the “first flight”. Within seconds of being catapulted, the aircraft took a nosedive into the water.

Two months later, Langley and his team once again failed as the aircraft toppled over the catapult launch pad into the water.

Langley researched, tested, destroyed a lot of equipment and exhausted the budget given to him by the government and the Smithsonian. He no doubt felt, as do many companies still, that if he threw sufficient resources at the problem he could arrive at a solution.

Sound familiar?

Ingenuity

Cambridge Dictionary defines ingenuity as “someone’s ability to think of clever new ways of doing something.” Oftentimes in the business setting, we find that the company is so focused on the mundane tasks of day-to-day operations that it fails to optimize and facilitate a creative environment.

Having ingenuity imbedded into the culture of a company is imperative for an organization to beat out its competitors. Apple didn’t become a $53 Billion (net income) business without having clever founders that defied the four walls encapsulating technology in the 1970s and 80s.

When you stop throwing money at your problems, ingenuity is required to adapt to be more forward thinking.

are you throwing money at your problemsThe Wright Brothers

9 days after Langley’s second failed attempt, the Wright brothers flew their plane 852 feet in 59 seconds. This became the first manned flight.

The difference between the success enjoyed by the Wrights and Langley’s failure… Budget.

Langley had an easier environment to work with, setting himself up for success. The Wright brothers did not have an easy environment that would help them better succeed. The Wright Brothers only spent $2,000 of their hard-earned money to create the first piloted aircraft capable of sustained flight. In comparison, Langley and his team at the Smithsonian spent the $70,000 grant and failed.

Because the Wright brothers were working on a shoestring, they had to rely on innovation and perseverance.   They had the same goal as Langley.  Money wasn’t the factor in their success, but their ingenuity and refusal to give up.

More money does not equal a greater chance of succeeding.

How You Can Avoid Throwing Money At Your Problems

In a panic because cash is tight or you’re facing problems? It could be that your basic unit economics are upside down.

There are three ways that you can avoid throwing money at your problems. Those include assessing your 1) profitability, 2) cash flow, and 3) unit economics.

#1 Assess Profitability

To stay in business you have to be profitable. So you’re making boatloads of sales. But is that revenue going to drop down to the bottom line? Or are you going to find that your revenue is tied up in your cost of sales and overhead?

When assessing your profitability, there are 2 metrics that you need to key into: return on assets and profit margin. If you find that these key items are turned upside down, you need some help.

Help can come in a variety of ways. To prevent you from throwing money at your problems, talk to your mentors, vet consulting firms before you sign the contract, use your internal resources to investigate and strategize solutions.

#2 Assess Cash Flow

I always say it… Cash is king!

If you run out of cash, default will be the ugly monster coming towards you. Start by unlocking cash in your business.

Another way to improve cash flow when in a tight spot is to analyze what collections ratios you are using, CEI or DSO. I’ve recently found that while they are both valuable for particular situations, using Collections Efficiency Indicator (CEI) is sometimes a better way to track your accounts receivable.

#3 Assess Unit Economics

Throwing money at the problem won’t change bad economics. Unit economics are the most basic function of a business.  Without good economics, you can’t make money no matter how much you sell.

Want to check if your unit economics are sound?  Download your free guide here.

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Mistakes in Troubled Times

There’s never a good time to make a mistake. However, errors during times of distress can be especially crippling. As we enter month 17 of the oil crisis, even minor missteps can have devastating consequences. To help you stay vigilant, we’ve detailed some common mistakes in troubled times that organizations make and how to avoid them.

Mistakes in Troubled Times

Changing Too Slowlymistakes in troubled times

Regardless of what kind of trouble they’re experiencing, companies tend to linger in their old ways for longer than they should. Failure to react quickly and an “everything’s fine” mentality will cause more damage the longer it’s sustained.

In month 17, have you already started to adjust to the economy? Instead of sticking your head in the sand, process information and take actionable steps to maintain a) a positive cash flow and b) the longevity of your organization.

Unrealistic Expectations

I’ve said it countless times to my coaching participants over the past year “the marketplace thought this oil crisis would last for 3-6 months, but economists project it to last 18-36 months.”

In this extended period of financial stress, it’s imperative to maintain a positive cash flow. Find holes in your business where you are bleeding. Here are some examples of what actionable steps some companies have taken to maintain positive cash flow:

  • ask employees to work 4 days instead of 5 days
  • give employees a pay cut with the promise that their position will be maintained
  • streamline your company by removing any job positions that do not return a profit for the company

This length of economic downturn is an opportunity for your company to regroup and create an action plan that could be a catapult for success after recovery.

(NOTE: Do you know the direct costs to a single unit? By downloading the free Know Your Economics tool, you will be able to shape your economics to return a profit. Click here to learn more.)

Overreacting

If you projected in June of 2014 that the economic downturn would last 6 months and are now sitting in month 17 with little to no cash, you’re not alone.

Because they waited too long, panic sets in causing many companies to overreact. Massive lay-offs, budget cuts, and cheaper quality materials are typically the cuts made at a moment’s notice. Before you know it, you’ve cut all your upper management leaving one junior account manager with the responsibility of 15 senior managers.

Reacting quickly and carelessly can have major repercussions. Instead, first gather adequate information. Before considering making a decision, think about how that decision is going to affect your organization in the long term.

Does your organization value experience or does what you do not require an experienced work force?  Those few thousand dollars saved by hiring cheaper, less-experienced people could make a major difference in your company’s survival.  But if your organization’s success is based upon relationships, it might be best to consider keeping the more expensive person.  People (both employees and customers) tend to follow people that they like.

Does your organization stand on producing quality product? If the materials for your product are expensive, then there may be a less expensive vendor with the same quality. But if your organization stands on its quality, do not react quickly by cutting the quality of your product. Stand on what your organization was built on and continue that legacy by looking at it from multiple angles. If you take a Rubik’s Cube and try to solve it by only looking at one side, you aren’t going to be able to solve the cube (I’m assuming you’re not a Rubik’s genius here).

Lack of Transparency

Often, senior management becomes tight-lipped when things get tough out of embarrassment or a desire to protect the team from bad news.  In times of distress, transparency with your team is more important than ever.  People are much more likely to work with you when they have the whole picture and understand how they fit into the solution.

If your organization has already downsized employees and cut costs, it’s time to bring the team together to brainstorm.  Some of your front-line employees might see things differently than the executives. Take some time and listen to them. Here are some tips to consider when bringing the team together.

  • Spread out the facts for every employee to see
  • Do not undercut your paying customers
  • Translate every action into a dollar value

Transparency will go a long way. If management proves to the front-line employees that they are fighting for the company (and thus the front-line employees), loyalty will be dramatically higher.

There are many options to ride out an economic downturn with your employees: limiting unnecessary resources, reducing pay and work hours, and scrutinizing every process before a decision is made. Do what’s best for your company, but know that you work with real humans.

It’s tempting to nickel-and-dime customers when times are tough for your company (I’m looking at you, airline industry).  But, your paying customer should not suffer due to your company’s distress. If cash is tight, focus on providing excellent customer service to your loyal customers. This is your most valuable resource! Improve your service, go out of your way to serve your customer without nickel-and-diming them. Just like you’re trying to create loyalty with your employees, create loyalty with your customers.

Failure to Understand Your Company’s Economics

One of the most common mistakes I see companies make is taking action without investigating the impact on the firm’s economics.  How will reducing your sales price in an effort to increase volume impact your bottom line?  Have you decreased overhead costs correspondingly?  If you reduce the cost of your materials and product quality suffers, how much do you need to sell to still cover fixed costs?

Knowing your economics is crucial to preventing mistakes from happening in troubled times. Translate every actionable item into a dollar item. This will help streamline what items can be tweaked, thus increasing your chances for success.

(NOTE: Want to double-check that you know your company’s economics? Download the Know Your Economics tool here.)

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Whatever decisions you make, be honest with your management, employees, and customers. It’ll benefit you in the long run.

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Return on Invested Capital (ROIC)

See Also:
Return on Equity Analysis
Required Rate of Return
Return on Asset Analysis
Financial Ratios
Weighted Average Cost of Capital (WACC)
Return on Capital Employed (ROCE)

Return on Invested Capital (ROIC) Definition

The return on invested capital is the percentage amount that a company is making for every percentage point over the [Cost of Capital|Weighted Average Cost of Capital (WACC). More specifically the return on investment capital is the percentage return that a company makes over its invested capital. However, the invested capital is measured by the monetary value needed, instead of the assets that were bought. Therefore invested capital is the amount of long-term debt plus the amount of common and preferred shares.

Return on Invested Capital (ROIC) Formula

Use the following formula to calculate the Return on invested capital:

Net Operating Profit After Tax (NOPAT)/Invested Capital = ROIC

NOPAT – This is the operating profit in the income statement minus taxes. It should be noted that the interest expense has not been taken out of this equation.

Invested Capital – This is the total amount of long term debt plus the total amount of equity, whether it is from common or preferred. The last part of invested capital is to subtract the amount of cash that the company has on hand.

Return on Invested Capital (ROIC) Example

Bob is in charge of Rolly Polly Inc., a company that specializes in heavy agricultural and construction equipment. Bob has been curious as to how his company has been performing as of late and decides to look at the company’s return on invested capital analysis. Surprisingly, the company does not keep track of the return on invested capital ratio. Bob decides that he will go ahead and run the ROIC analysis, and obtains the following information:

Long-term debt – $25 million
Shareholder’s Equity – $75 million
Operating Profit – $20 million
Tax Rate – 35%
WACC – 11%

Plugging these numbers into the formula Bob finds the following:

$20 million – (20 million * 35%) = $13 million

$13 million/($25 milion + $75 million) = .13 or 13% = ROIC

To see how well the company is actually generating a return, Bob then compares the 13% to the WACC which is 11%. Thus, Bob find that the company is generating 2% more in profits than it cost to keep operations going.

If you want to be more valuable, then click here to download the Know Your Economics Worksheet.

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Supply and Demand Elasticity

See Also:
Economic Indicators
Balance of Payments
Stagflation
The Feds Beige Book
What are the Twin Deficits?

Supply and Demand Elasticity

Supply and demand elasticity is a concept in economics that describes the relationship between increases and decreases in price and increases and decreases in supply and/or demand. We have described it in greater detail below.

Price Elasticity of Demand Definition

In economics, demand refers to customers’ need or desire for a given product or type of product and their eagerness to purchase that product. The more customers want a certain product, the more demand there is for that product. Less desirable or necessary products have lower demand in the marketplace.

What is elasticity of demand? Price elasticity of demand refers to the degree to which demand is influenced by changes in price. Basically, price elasticity of demand describes consumers’ sensitivity to changes in price. For example, if the price of a product suddenly goes up, broadly speaking, fewer people will buy it because it is more expensive. Perhaps people can no longer afford the product, or perhaps they feel the product costs more than it is worth. Regardless, to some extent, at least academically speaking, when prices rise, demand falls.

If a slight price increase causes a large decline in demand, price elasticity is high. Similarly, if a slight price decrease causes large increase in demand, elasticity of price is high. On the other hand, if a large price increase is required to cause any decline in demand, price elasticity is low. And if large price decreases are needed to cause any increase in demand, elasticity of price is low.

In sum, if a small price change causes a dramatic change in demand, price elasticity is high – consumers are highly sensitive to price changes. If small price changes cause little or no effect on demand, and substantial price changes are needed in order to see any effect on demand, then price elasticity is low – customers are less price sensitive.

Elasticity of Supply

In economics, supply refers to the availability of a particular product in the marketplace. If a particular product or type of product is widely available in the marketplace, that product is amply supplied. If there is a dearth of a particular product or product type in the marketplace, that product is in short supply.

Supply is also related to price. When the price of a product rises, supply will increase. This is because the makers of the product want to maximize profits by selling as much of the product as they can while prices are high. This will flood the marketplace with that product, leading to an eventual overabundance of the product. When products are too abundant – when there is too much supply available – prices fall. If everyone in town has the same red hat, you won’t be able to charge very much for yours.

If you want to find out more about how you could utilize your unit economics to result in profits, then click here to download the Know Your Economics Worksheet.

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Market Dynamics

See Also:
Asset Market Value vs Asset Book Value
Efficient Market Theory
Market Positioning
Marking-to-Market
Business Cycle
Market Segmentation
Brand Equity

Market Dynamics Definition

Market dynamics, defined as the factors which effect the supply and demand of products in a market, are as important to economics as they are to practical business application. Many economists established market dynamics. Arguably, they are most developed in Porter’s five forces of competition.

Market Dynamics Meaning

Market dynamics means the factors that effect a market. From the theory of economics they would be supply, demand, price, quantity, and other specific terms. From a business standpoint, market dynamics are the factors that effect the business model which involves the applying party. In comparison, the dynamics may be the price of a barrel of crude, total oil production, total national or international stockpiles of oil, the price of other energy commodities, and more for an oil firm. Whereas for a web 2.0 business, a social network for example, market dynamics analytics may be the total amount of free time spent online for both national and international users, amount of money spent online each year, growth of online advertising, and more.

For a prudent business, market dynamics are included in the market analysis of their business plan. Furthermore, these factors affect the business so much that it would be neglectful to exclude them. In conclusion, market dynamics play an important role in the marketing plan of a business. They may also play an important role in other areas such as cost of goods sold, distribution, logistics, and more.

Market Dynamics Example

Charlotte is writing a marketing plan for her new business. Charlotte sees a real need in the fashion industry for high quality accessories like purses and necklaces. Her experience in retail gives her a strong base to refer back to.

To complete the marketing plan she must complete a competitive and industry analysis. Essentially, she needs to assemble a market dynamics analysis for the fashion industry, with respect to accessories. Then she needs to understand them so she can fill a space for customers not being served.

Charlotte starts with the industry analysis. She looks at a number of statistics: consumer spending rate, retail growth, growth of the fashion industry, growth of brick and mortar business sales, and the competencies of wholesalers. Here, she is assembling market dynamics in order to find whether the market can support her business. She knows this an important foundation for her idea.

Next, Charlotte performs a competitive analysis. She finds all competitors and similar businesses. Then, she analyzes their strengths, weaknesses, and the perception of these companies to the average consumer. From this she realizes a matter of key importance: though clothing, cosmetics, and other stores exist there is no provider for the accessories which complete an outfit. She is satisfied and resolves to continue research to keep up to pace with her industry.

Prepare for the best… and the worst. Download the External Analysis to gear up your business for change.

Market Dynamics

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