Management Strategies for Small Companies

After looking at hundreds of small businesses and working on a number of them, I have seen certain patterns of conduct recur again and again that lead to eventual failure. If a company is in difficulty, it is almost always a management problem, scarcely ever bad luck.

When a company survives for many years but finally comes upon hard times, it usually means (a) that there is a valuable core of talent and expertise somewhere in the corporate structure yet (b) some persistent management inadequacies have gradually eroded its strengths and left it vulnerable to whatever adverse fortune it encounters.

In a moment, I shall get into those areas that cause management the most trouble, but first permit me to clarify one point. While this article focuses on the lessons I have learned about operating small manufacturing businesses, much of what I discuss is applicable to the practical problems faced by operating units of sizable companies.

In my judgment, there are three principal areas of weakness in small businesses that cause trouble, all of them management centered.

1. Growth of sales is commonly seen as the solution to all problems. There is an unawareness that, except in the short run, there is no such thing as fixed overhead. Managers, trapped by the concept of marginal income accounting, bring out additional products, believing that their overhead will not be affected.

2. Inadequate product-cost analysis blinds managers to the losses incurred by adding new products willy-nilly. Usually, there are one or more products or product lines that should be dropped.

3. Gearing operations to the income statement, while ignoring the balance sheet, is all too common. Lack of concern with cash flow and the productivity of capital employed can be fatal. Managers tend to seek new funds instead of making better use of those they already have.

1. Growth for Growth’s Sake

The most common cause of trouble is the widely held belief that the only road to success is through growth. Many businessmen see growth of sales as the solution to all problems. It seldom is. Growth is not synonymous with capitalistic success. In fact, shrinking the number of products or product lines is usually the surest route to better profit and higher return on investment.

The mania for growth is commonly expressed in the battle to increase sales. Standard methods of accounting tend to encourage the belief that higher profits automatically follow from higher sales. Several standard accounting techniques tend to mislead those who accept standard cost allocations as gospel.

Marginal income accounting

Much has been written about the advantages of marginal income. The theory is that, for a short period, additional sales can be added to the normal sales volume profitably even at prices too low to cover a proportionate share of fixed overhead. Managers often do this because they presume that 100% of the fixed overhead of the company is borne by their regular business anyway.

However, pricing your product so that it does not cover a full share of overhead is dangerous. Except for rare and well-controlled exceptions, marginal business taken to keep the operation going incurs the same overhead costs as the regular business and, by adding to the complexity of the total operation, often requires more than normal overhead.

Recently, one company manager proudly mentioned that his leading accounting firm had advised him to price all products to obtain any profit margin over his direct material and direct labor costs. He had taken this advice to heart. No wonder his company was in trouble.

Yet, if the overhead really cannot be cut during a short period of overcapacity, it may make sense to take added business at prices that will pay less than full overhead expenses. Even a modest contribution to paying these expenses for that period may be better than none. However, the danger is that an emergency measure often becomes standard practice. It is a good way to go broke.

Break-even accounting

Another management tool that inadvertently encourages growth for growth’s sake is break-even accounting. Like marginal income accounting, the theory is that certain elements of overhead cost vary with the volume of operations, while others, which are called “fixed costs,” do not. The sale price is set to provide for material and labor costs, plus variable overhead costs, plus an additional increment to allow for fixed overhead costs and profit. When the sales volume is high enough in a given period to absorb all variable costs as well as the lump of fixed overhead costs, you have reached the break-even point. The margin above variable costs on additional sales goes entirely to profit, because all the fixed overhead costs have already been taken care of.

No wonder a manufacturer gloats about a high-volume month, because, although he makes no money and actually loses until the volume reaches the break-even level, his profit on volume above the break-even point is disproportionately large.

The fallacy of break-even accounting is the assumption that expenses are easily divisible into fixed and variable. Overhead is rarely as fixed as accountants are inclined to think, except for very short periods. In any long-range analysis of a business, there is no such thing as fixed overhead—it is all variable to some degree, even such items as rent, heat, light and power, depreciation and amortization, professional services, and executive salaries. The terms “variable overhead” and “fixed overhead” would be better called “overhead that varies immediately with the level of activity” and “overhead that varies in the long run with the level of activity.”

Except in the very short run, there really are few, if any, fixed expenses. If you lease a 100,000 square-foot plant for a ten-year term, cost accountants will normally treat your rent as a fixed expense. But is it really? If you don’t have enough space, you can rent more and thus increase that expense. If you have too much space, you can sublet part of the space, or if that is impractical, you can even buy your way out of the lease and move to a smaller building. Thus rent expense can go up or down.

The danger is that some managers tend to pay no attention to so-called fixed expenses. Even worse, they assume that they are stuck with them and see an increase in volume as the only means to pay for them.

One able executive of a large merchandising company recently said: “Our biggest problem is sales. Our industry has high fixed costs, and we have to promote hard to maintain a rate of sales to cover these costs. Securing more sales is far and away our No. 1 problem.” This is a typical, mistaken business attitude: assuming that the cost structure is a given and that the company must grow to cover all the overhead.

Variation of break-even costing

Manufacturers often take their profits only at the tail end of a run, absorbing all their fixed overhead before any profit is counted. In airplane manufacture, for instance, it is common to determine how many planes must be sold before the company breaks even. The danger of this variation of breakeven accounting is that it may stimulate concern with volume of sales, not with margins.

As such, once the fixed costs have been absorbed, profits on the last increment of volume (either monthly or, if it is a one-shot product, by unit) are big, thus encouraging the attitude that more is automatically better.

It is understandable that accounting practices permit amortization of much of the special costs of a particular project (largely tooling and start-up costs) over the estimated number of units expected to be produced. Also, management may be wise to plan for low sales to avoid the unpleasant possibility of taking a big write-off on unamortized costs should the product not sell well. The result, however, is to put the major emphasis on marketing effectiveness rather than on cost effectiveness. It is not surprising, therefore, that increasing sales is the generally accepted prescription for all corporate ills.

2. Inadequate Cost Analysis

At best, cost accounting is an inexact study with limited goals. It is a method of looking at the direct costs attributable to a particular product or activity. However, it does a poor job of allocating indirect costs. Old and new product lines are normally charged the same proportionate amounts for overhead, although the more recently added lines cost far more to start up. The new product line that adds one more straw to the management load rarely gets charged as much as it should, while the well-established line that runs itself is expected to carry the load for the new line.

Research and development costs, for instance, are usually charged to current operations—which they don’t benefit—rather than to the new lines that the R&D is supposed to develop. It is probably necessary to have the old products subsidize the introduction of the new ones. Many managements are scarcely aware, however, that they are doing this. Therefore, they undervalue the profits on the old line and understate the costs in bringing out the new one. The effect is to encourage costly new projects and downgrade current results.

Advantages of simplification

Once a manager understands how to interpret his cost accounting information, however, he can see that shrinking is a good strategy. If the manager is willing to recognize that all overhead expenses are variable (although a few expenses take time and effort to change), it is easier for him to identify the costs which can be eliminated when his organization is trimmed down in size and complexity.

A few years ago, one of our operating companies disposed of a line of portable positive-displacement pneumatic machines that had an annual sales volume of about $500,000. Although the line was a natural companion to a much larger and long-established line of fan-operated equipment and a prodigious effort had been devoted to get it going, it had not made money and the prospects of success were poor. We finally made the painful decision to sell the line for a nominal amount. The buyer was one of our employees, who set it up as a separate business that later proved modestly successful.

The beneficial effects of that sale on the company’s operation were substantial and almost instantaneous. Our balance sheet improved dramatically as we collected the remaining accounts receivable, worked off the inventory, and—by buying no more material—cut our accounts payable. Our earnings improved more than the elimination of this relatively minor line seemed to justify. Only then did top management realize how much this one activity had demanded in attention and effort from almost everyone in the parent company. The product line had had a disproportionately high overhead, but the figures didn’t show it.

The advantages of simplification are hard to quantify, but they are real. Despite all that the computer can do to make possible a wide span of control, there is no better road to efficiency than to eliminate complexity entirely, usually by shrinking the business to a smaller and more manageable size.

The manager’s job is to maximize the opportunities of the business, not to solve all its problems. He can do this best by focusing on a limited number of objectives to the exclusion of all the irrelevancies of much business activity. It is not easy. As E.F. Schumacher says, “Any third-rate engineer or researcher can increase complexity; but it takes a certain flair of real insight to make things simple again.”1

In simplifying a business, the best place to start is usually with the products. This is where the ball game is really played. Take each product line and analyze it separately. In most companies with more than one product line or group of products, there are some that are contributing to its growth and success and some that are dragging it down; it takes a careful study to tell the difference.

If the company has adequate product-line cost information, so much the better. Learn how the information is developed and analyze whether the cost allocations between product lines are reasonable. Look for the low-margin product lines that represent a substantial part of the volume.

For example, if a line has been a company mainstay for a long time, your people are likely to tell you that, despite its low margins, it is absolutely necessary to keep this line because of the overhead it absorbs. You will probably also be told that it carries more than its share of overhead and that it really does better than the figures say. In my experience, this is usually not true. In fact, such a line may be doing worse than shown on the statement and may have more actual indirect expense than is charged to it on the accounting books.

Often one line is holding a company down. In one of our operating companies, we found a major product line that had been the backbone of the company for almost a generation. The line showed a minor loss year after year, while gradually declining in volume both absolutely and relatively in relation to a newer line marketed through other channels. This old line was being marketed to original equipment manufacturers (OEMs) in an industry where the smaller customer manufacturers were gradually being driven out by a few large survivors, who had become demanding buyers of components. The company’s newer line of products, however, was sold to the consumer market through several thousand distributors. And it was growing profitably every year.

We were told that the company could not survive without the old OEM line because the overhead it carried made the profits on the distributor line possible. But that was not true. The OEM line required extensive engineering for annual model changes for each separate customer, had generally more stringent requirements for quality performance, and had a greater variety of more complicated mechanisms. Yet the customers demanded immediate response to up-and-down schedule changes that made production scheduling beyond a few days almost impossible to achieve.

We sold off the OEM line. And, by so doing, we were able (a) to cut the overhead more than proportionately, (b) to free funds tied up in a nonprofit program, and (c) to turn the company from a big loss to a big profit in less than a year.

What you need to know

In studying product lines, management should ask some basic questions. In this section, I shall discuss seven of them.

1. Is the sales volume of the product or product line rising or falling? Most products have a life cycle of from 5 to 20 years (depending on how you define “product”). If sales are on the downtrend, spend little or nothing to keep it from dying a premature death.2 If it is losing money and it is past its peak, let it die quietly. You should spend money on the product that is on its way up. Indeed, if this product already has a good margin, it probably can be increased even more.

2. Is the product line making a profit? If it is not profitable, as shown by the company’s existing cost system, don’t lightly accept the argument that it is really doing better than the figures show, that it doesn’t use as much overhead as is allocated to it, and that, if only such and such were done, it would start making money. Particularly, don’t listen to this argument for a product line the company has had for years which once made money. Better than revive it, let it die quietly.

3. What are the gross margins of the different product lines? There is no fixed rule for a satisfactory gross margin (the difference between net sales price and the total cost of material, direct labor, and applicable factory overhead). One manufacturing company had a material cost alone that represented over 90% of sales price, but the product had a very satisfactory profit. The reasons: the material was expensive but not bulky, and the company made only a slight addition to the product before selling it to a few large users; in addition, operating expense was negligible and the company didn’t pay for the raw material until after it had collected for the modified product from its own customers. Consequently, almost all the gross margin went directly to the owner’s salary and profit.

In general, however, in the manufacturing business, if you are to have a profit of at least 10% on sales before federal income taxes, your gross margin should be no less than 35% and preferably well over 45%. If your gross margin is low, unless you can raise selling prices (the first place to look) you face a long struggle to improve operating efficiency. For, while you battle to reduce manufacturing costs, you can be sure that your competitors are plowing that field too. You may find later that your hard-won improvements have only kept you from losing more ground.

4. What do your customers think of each product line, its price, its quality, and your company’s service? Most companies have their own definition of their products’ quality and competitiveness, but the customer is the only person who is entitled to judge quality. He often has quite different ideas from you about what is important and what is not. Often products that managers or owners think are marvelous fail miserably in the marketplace, for reasons that are entirely unanticipated.

One maker of television sets claims that its product is better because the sets are handcrafted. The company does make a superior product, but handcrafting doesn’t impress me. Personally, I trust machine manufacture more. The customer most likely doesn’t care how difficult it is to make. If a product is as hard to make as some manufacturers advertise, it probably can’t be very reliable. Quality is only what the customer says it is.

5. Is the sales department determining the pricing? If so, you can bet the prices are too low. Salesmen rarely believe that they can get a higher price for the product until they are told by management that they have no choice. (Overly marketing-oriented officers have the same failing.) It is amazing how often the customer will pay more with little or no complaint, despite all the salesman’s warnings that to raise the price is suicide.

6. Is your sales department’s pitch that “we have to have a full line”? Only the “full line” approach justifies continuing to make and sell low-volume items which are expensive to tool and manufacture and which, per unit sold, cost a fortune to catalog and carry in stock. If your competitor carries a full line, your sales people will insist that they cannot compete unless they have all the items too, because the buyer wants to purchase from one supplier.

One-stop purchasing is a good sales gimmick but often is not good business. The Crane Company had the most complete line in the plumbing industry, but its losses mounted until Thomas Mellon Evans acquired it, eliminated the low-margin items, and thus put it back in the black.

7. Does your sales program offer a wide variety of options, extras, and specials? Custom products always cost more and, unless the volume is large enough so that some economies of scale can be realized, they are certain to lose far more money than the books show. Many companies gradually add more and more variations to their line to suit the particular specifications or whims of various customers. These specials are ordered as a matter of habit for years thereafter, even when the customer can do just as well with a standard product. If you rigorously cut out the specials, you can usually convert the customer to a standard item. If you can’t, you are probably better off losing his account.

All of the foregoing should aid you in cutting out low profit or unprofitable product lines. If you are lucky, you can sell off the line to a competitor or someone who wants to get into the business. If you are not able to do this, just stop making it. One way to stop is to put into effect a large, across-the-board price increase. If the line has been grossly underpriced, you may not lose much business and may have turned a bad line into a good one. But even if you lose most of the business, a few of your customers, although they may object noisily to the price, may continue to buy from you—at least for a while—so that you can favorably dispose of your inventory.

When you cut out a line entirely, several things happen. Because your sales volume is reduced, your accounts receivable in that line turn into cash. You stop buying inventory and stop putting in direct labor, and this saves you more cash. You terminate all personnel involved in the line except those necessary for the final salvage operation, saving still more cash. You simplify your total operation which makes even more savings happen. You will probably need less machinery and may be able to sell off the surplus for cash. Finally, even if you can’t sell all the inventory, you can scrap the rest, thus freeing up space which you can put to better use or even no use at all.

Closing down a product line is usually recorded on the accounting books as a loss. However, you are merely recognizing losses that were actually incurred sometime ago but don’t show on the books yet. You might as well bite the bullet now.

3. Lack of Balance Sheet Concern

Another common failing is gearing the operations to the income statement and ignoring the balance sheet. The management of one company International Science Industries purchased from a large conglomerate had never seen a balance sheet because the parent supplied all its cash needs automatically on request. Lack of concern with cash flow and the productivity of capital, however, can be fatal to the small company that is on its own. Your best source of capital often is hidden in your balance sheet. I have become particularly aware of this because in most turnarounds the first concern is cash flow.

Accounts receivable

Look through your assets to see what you can turn into cash. Often, the quickest and best source of cash is your accounts receivable. An intelligent analysis of accounts receivable can be made without knowing much about the details of the business. If the book figure for accounts receivable is higher than the equivalent of 40 to 50 days of company sales, you may be sure that there is work to be done.

Collecting amounts owed you by customers is a boring and unpleasant job. In poorly managed companies, the job is often neglected. If the company has not earned a profit, there has been no income tax incentive to write off uncollectible accounts. As a result, these uncollectibles continue to clutter up the balance sheet, making it harder to identify the accounts you should be working on.

Obtain a report showing all of the accounts by invoice number divided into categories by age of invoice (less than 30 days, 30 to 60 days, 60 to 90 days, over 90 days). Such a report will show you at a glance where the problems are; establish the procedure if you don’t already have it. Decide who is to police the accounts receivable and then ensure that they are really worked on.

In many companies, the salesmen are not penalized when their customers have a poor payment record. Salesmen are naturally reluctant to irritate the people on whom they rely for business by insisting that the customer really should pay his bill. The result is that the only customers who make timely payments are those who do so automatically, without the needling that many companies expect before paying any bills. If you find that the salesmen are responsible for collection, reassign the responsibility to someone in the accounting department who has no compunction about being firm with a slow-paying customer. What good is it to make a sale if you don’t get paid?

Once the salesman is freed from the responsibility of collection, he can sympathize with the customer about the demands of that “damn credit department” and spend his time selling, which he does well, instead of collecting, which he does ineffectively—if at all.

Study the accounts receivable records to see whether the financial department is doing a good job. If you find a host of small unpaid balances in the receivables, and, at the same time, many unmatched credit entries, then you know that procedures don’t exist or aren’t being followed for matching cash receipts with the appropriate invoices in order to straighten out any discrepancies. Examples of the latter are when the customer pays for the product but doesn’t pay for the freight, or takes an unauthorized discount, or in any way pays less than what the invoice calls for.

If these discrepancies are ignored for long, it becomes almost impossible to straighten them out without writing off your loss. If an adequate job has been done, such a writeoff will never be necessary. I am particularly partial to nit-picking bookkeepers who keep tidy books and work at cleaning up all (and I do mean all) open items within a reasonable period.

If you can find time to be your own credit manager and to do some of the telephoning to delinquent accounts, you will be rewarded with new insights into your business. When you talk to a customer who hasn’t paid his bill, you find out why he isn’t paying. Often it is because your own company has made mistakes that no one has done anything to correct.

You also discover which salesmen are doing a poor job in handling difficult product and sales problems. If they aren’t solving such problems as they arise, they are not helping to build your company. Instead, they are effectively tearing it down.

Inventory items

If your company is operating in the black, you have every incentive to write down or write off any inventory that is no longer worth full value. Necessarily, all accountants and auditors have to rely on management judgment as to which inventory is still useful and which is obsolete. Their statistical analyses of inventory aging can be very helpful, but the manager is the one to decide which items are good and which are not.

Even when there are no favorable tax consequences, a physical housecleaning is good. Poor housekeeping generally goes with poor management. Some years ago when a company I ran first took on a turnaround, we trucked out 23 semitrailer loads of scrap inventory in the first three weeks, inventory that the previous management had been afraid to write off the books, although they (and we) knew that it was valueless.

Most of us hate to throw things away. Somehow the right time never seems to come. But never has anything turned up to make me thankful I had not thrown something out or to make me regret that I had. It is good for the soul to roll up your sleeves and to clean house physically. And it is good for the business, too.

Fixed assets

Managers are likely to neglect looking into their fixed assets for hidden capital. Somehow land, buildings, machinery, and equipment seem sacred. If the company has been in existence many years, these assets are usually deeply depreciated on the books. However, because of inflation, these assets are likely to be worth far more than book value. (Land, although it is not depreciable, usually has inflated in price too.)

The capital you are actually employing in the business is not measured by the net book value of these assets, but by their current market value. Once you recognize this, you should seriously consider whether you need all of them and whether you are using them effectively. If you have a fully tooled machine shop to support your manufacturing effort, can you justify tying up that much capital in expensive equipment when there are competent subcontractors available to do your work? If not, you can close it down, sell off the equipment for cash, free up some space, and reduce your payroll.

My general rule is to subcontract whenever possible all work for which our company has only an intermittent need. If the work is a follow-up step in the production process that, if not properly done, can damage our products, we may make an exception and invest the money to do it ourselves. Heat treating of critical aerospace parts is a typical example of an exception.

Also, when we manufacture in high volume, it is advantageous to integrate backward as far as possible and to do it ourselves. Only in that way can we keep our unit costs down. But we still let outsiders make our tools.

One important management decision is whether to continue to operate at all in a given location. Years ago, it may have been necessary to have satellite plants in various cities to serve your customers. But is that still true, and, if so, what is it costing you to serve those customers? Several years ago, International Science Industries acquired a manufacturing company with plants in five cities around the country. Within a year, we closed and liquidated two of them. We were able to shift much of the business to the remaining three plants. Thus, while sales volume scarcely declined at all, costs plummeted. More important, this shift released a large chunk of capital for better use.

A Final Reminder

The name of the managerial game is return on investment. ROI is the ratio between the profit of the operation after tax and the assets employed. Management tends to look only at the former, neglecting the latter. In seeking to maximize profits, attention is often focused exclusively on sales. The stockholder, however, has no interest in sales; he looks at earnings per share, because they largely determine how much the stock sells for and what dividends are paid.

If assets employed can be sharply reduced, even if profits drop a little, ROI will increase and the stockholder will be better off. Is this a risky strategy? Not if the assets were previously employed inefficiently. Putting the company in a financially sound position is a first step.

Once the company is in a solid position, you can, if you desire, go after renewed growth. Or, if you get hooked on the beauties of simplicity, you may just keep on making money at that level.

1. E. F. Schumacher, Small Is Beautiful (New York: Harper & Row, 1973), p. 146.

2. See Joseph A. Morein, “Shift from Brand to Product Line Marketing,” HBR September–October 1975, p. 56.

A version of this article appeared in the January 1976 issue of Harvard Business Review.