by Norm Brodsky
It quickly became apparent that Anisa was lost. She realized something must be wrong because she was having trouble paying her bil s every month, but she couldn’t understand why. She knew her costs, and she knew how much she typical y marked up the price of her products. How could she be chronical y short of cash? The problem, she figured, was that she didn’t have enough sales. In fact, her real problem was that she wasn’t gathering simple, easy-to-get information that would have told her what was happening in her business.
That’s because there were only two possible explanations for her situation. One was that she was not making enough gross profit on her sales to cover her other expenses and stil get a decent return. The other was that the cash she generated was going someplace other than her bank account. The second explanation seemed unlikely, given the nature of her business. She was a packager and marketer of cosmetics brushes, sponges, bags, and gift items, which she sold to major department stores and cosmetics companies throughout the United States. Anisa would get the orders and forward them to manufacturers in the Far East, who then shipped directly to the customers. The manufacturers got paid after she got paid.
So I knew that her cash couldn’t be going into inventory: she didn’t have any. And I doubted that she had much of a receivables problem, given the pressure she was under to pay her own suppliers. My guess was that she was making too many low-margin sales. But which ones, and why?
Was she charging too little for certain products? Was she giving too many breaks to certain customers? I couldn’t find out because she hadn’t kept track. I had her go back and write down her sales for the previous three months, showing me the total on every customer invoice and the cost of goods sold for each of those orders. One look at the list, and I knew she had customer problems. She’d lost money on some of the orders. On others, she hadn’t made nearly enough to survive.
Next I sent her a form on which I asked her to start tracking her sales and gross margins by product category. At the end of each month, she was to write down the sales, cost of goods, gross profit, and gross margin (that is, gross profit as a percentage of sales) on every type of product she carried, both for that month and for the year to date. Then she was to calculate the totals for the company as a whole. The whole exercise took less than thirty minutes a month and al owed her to see at a glance how much cash she was generating internal y and where it was coming from.
Meanwhile, she continued to track her monthly sales and gross margins by customer on a separate sheet of paper.
The reports were a revelation. Anisa later told me that it was like reality hitting her in the face. For the first time, she saw what it took to make money in business. Before, she said, she’d been winging it. Afterward, she began to understand how she could be in control. Not that she was suffering from low gross margins across the board. She was doing fine with some products and customers, but the others were dragging the average down. I told her there are basical y four ways to deal with this type of situation. You can raise your prices. You can reduce your manufacturing costs. You can say no to low-margin business. Or you can find other products that you can sel at higher margins. Anisa decided to do al four.
Understand, my point here is not that Anisa was wrong to have accepted low-margin sales in the first place. When you’re just starting out in business, you have to be flexible, as I noted earlier. You have to put together the pieces of the business much as you would assemble a puzzle. In the beginning, those low-margin sales may have helped Anisa build relationships with her manufacturers—by providing enough volume to make it worthwhile for them to do business with her on credit. As she soon discovered, their credit was the key to her survival.
But once she’d figured out how to earn a living from the business, she should have immediately turned her attention to increasing its profitability.
She didn’t because she had no idea what was going on. She wasn’t even aware of the decisions that had to be made. She was operating on instinct and guesswork, rather than information, and it takes information to survive.
You need to start gathering that information from the beginning. In particular, you need to track your gross margins. High gross margins translate into high gross profit, and gross profit is the main source of the cash you’l need to support yourself and build the business.
And don’t make the mistake of automating the tracking process. You have to write the numbers out by hand and calculate the percentages yourself. If you let a computer do the work, the numbers become abstract. They start to blend together. You don’t focus on them. You don’t absorb them. You don’t get to know them as wel as you must if you’re real y going to be in control of your business.
Don’t get me wrong. I am not anticomputer. On the contrary, I began using computers in my messenger business long before anyone else in the industry. My businesses have always used the best technology available. I myself have al the state-of-the-art computer toys, not to mention a degree in accounting, and I’ve started several businesses. But seven years after I started my records storage business, I would stil sit down every month to track the key numbers by hand—and by then the business was doing mil ions of dol ars in sales.
It’s al part of the education process, and you can’t skip over it. I don’t care if you’re a Harvard MBA who’s spent the past ten years at McKinsey.
You stil need to track your numbers by hand. I guarantee you’l learn something. Anisa sure did. Armed with her newfound knowledge, she took charge of her destiny and built Anisa International into one of the leading suppliers of cosmetics brushes in the country. In 2006, Target Corp.
named the company Vendor of the Year in its beauty division, an award given to suppliers that demonstrate excel ent business practices, innovative design, and superior customer service. Anisa could never have accomplished so much if she hadn’t had a good grasp of the numbers. Tracking them by hand in the beginning helped her to develop one.
Levers of Control
I real y can’t emphasize enough the importance of developing a good feel for the numbers. In particular, you need to identify those that wil alert you to potential problems before they become serious, so you can make the right decisions in time to prevent further complications.
I’l give you an example from my records storage business. In the spring of 2003, we were al geared up for a big growth spurt when I received the two-page report I get on each of my businesses every Monday morning. Among other things, the records storage report tel s me how many new boxes we put away the week before. For months the number had been increasing steadily as our Manhattan-based customers—mainly law firms, accounting firms, and hospitals—struggled to get their records off-site in the wake of 9/11. In one year we grew 55 percent. But as I looked at the report that morning, I was shocked to see that, the prior week, we’d put away almost 70 percent fewer new boxes than the week before.
That stopped me dead in my tracks. The new-box count is one of my key numbers—a reliable indicator of what my overal sales for the week actual y were. Although new boxes represent only one element of my total revenue, I’d learned by then that our sales rise in direct proportion to the number of new boxes we add in any given time period. Tel me on September 1 how many new boxes came in during August, and I can tel you our overal sales for August within 1 percent or 2 percent of the actual figure. If the new-box count had dropped by as much as the report indicated, we could be looking at a significant slowdown in our overal growth rate.
That was important information, and I wouldn’t have gotten it so fast if I hadn’t figured out a formula for calculating total sales based on new boxes. In the beginning, it was by no means obvious that there was such a formula. We get revenue from many sources, including optional services, removal charges, and special projects, not to mention storage fees for boxes we already have. New boxes account for only a smal percentage of our overal sales. If I didn’t have a key number, I’d have to add up sales from al the different sources to get the total. A
s a practical matter, that would mean waiting until we did our monthly bil ing.
But I didn’t want to wait that long, and I knew I wouldn’t have to if I could find a number that rose at the same rate as overal sales. After years of searching, I zeroed in on the new-box count and was eventual y able to devise a formula that al owed me to estimate sales within 1 percent or 2
percent of the actual figure. Why the new-box count? I have no idea. It’s a little like being able to determine the sales of a department store by counting the number of shoes it sel s. Yet, for some reason, the formula works.
I believe every business has key numbers like that one. A restaurant owner I know can predict his evening’s receipts by the length of time customers have to wait for a table at 8:30 p.m. My friend Jack Stack, the cofounder and CEO of SRC Holdings Corp. and the pioneer of open-book management, told me about a guy with a gear-making company who knows his sales by the weight of the gears that have been shipped. Not the dol ars. Not the orders. Not the number or type of gears. The weight.
Indeed, the best businesspeople I know al have certain key numbers they track on a daily or weekly basis. It’s an essential part of running a successful enterprise. Key numbers give you the financial information you need to take timely action. Business moves too fast to wait for the monthly, quarterly, or annual statements from your accountant. By the time you get them—weeks or months after the end of the period—you’re already dealing with the consequences of whatever problems may have arisen when you weren’t looking. You’ve probably missed out on a number of opportunities as wel . You need real-time information, and the only way to get it is by coming up with a set of simple measurements you can use to figure out what’s happening in your business at any given moment.
Of course, one of those measurements wil relate to sales, although I hasten to add that it shouldn’t be the only one. If you just track sales, you can get into serious trouble. Sales don’t make a company successful. Profits and cash flow do. A lot of companies land in bankruptcy court because their owners focus so much on driving sales that profit and cash become an afterthought.
That said, it is important to have a key number for sales. What it wil be varies from business to business, and it’s seldom self-evident. I often have to fol ow the numbers for years before I can identify a single measurement I can use to tel me quickly what my sales are.
Take the document destruction business that we launched in the spring of 2000. As I noted earlier, we get our revenue from two types of services. One service involves so-cal ed cleanouts, wherein we destroy a large volume of sensitive documents that a customer has accumulated over a long period of time. The other service is for customers who routinely produce material that needs to be destroyed on a regular basis. In those cases, we place locked bins around the customers’ offices.
The revenue from the cleanouts is easy to track, since we do only a few each month. The bin business is much trickier because of the different types of bin, the different sizes of each type, the varying frequency of pickups, and so on. So there are a number of factors that go into determining overal sales. After three years of tracking them, I stil couldn’t identify the key number for sales in the bin business. One possibility was the number of new bins added. Another was the total number of bins outstanding. Or maybe it was the number of pickups. Then again, it could have been something else altogether. I tracked al of those numbers and several others. Final y, I decided that the number of bins scanned weekly correlated best with sales as a whole. But it was a long time before we had enough experience, and enough bins, to understand the relationships between the numbers.
How important is it to find that key number? Consider what happened in my records storage business after I saw the decline in the new-box count. Up to that point, we’d been in constant hiring mode. It took lots of people to handle al the new boxes coming in, and we had to recruit four times as many people as we needed, since only one out of four new hires wound up staying with us. When I saw the drop in the new-box count, I was immediately concerned that our rate of growth might be slowing, which would mean we wouldn’t have as much cash flow as we’d anticipated.
To be sure, the drop might have been a one-week aberration, but I didn’t want to take a chance. If our annual growth rate real y had fal en as much as the drop indicated, we were already overstaffed by about thirty people. While we could let normal attrition take care of that problem, I didn’t want to keep adding people at the planned rate. If sales didn’t bounce back, we might be forced to do a layoff.
So, based on one week’s numbers, I put in a temporary hold on hiring. “I want to protect everyone’s job,” I said. “Let’s see how this plays out.” We waited for sales to revive, but the slowdown continued. As one week turned into one month and then four months, it became obvious that we weren’t dealing with an aberration. The market had changed. Evidently, customers had finished clearing out al the records they’d wanted to move off-site after 9/11. Although our sales were stil growing, the rate had plunged from 55 percent to about 15 percent annual y.
My caution was vindicated, which is the best part of having a key number. Afterward, you look like a genius. My staff was very impressed that I saw the reduction in our growth rate so early and acted so quickly. I just told them it was al in the numbers.
Paying for Growth
Let me just return to the point I made earlier about the importance of tracking things other than sales, especial y cash flow. I mean, sales are nice, and profits are nicer, but businesses live or die on cash flow. Where most first-time entrepreneurs trip up is in failing to understand that more sales almost always mean less cash flow—and less cash flow means trouble.
As usual, I speak from experience. I had no concept of the relationship between sales and cash flow when I started my first company. I thought sales were everything. If someone came and offered me a mil ion dol ars of new business, my only question was, “When does it start?” I took al the business I could get, as fast as I could get it, and the company grew like crazy. Our sales went from zero to $12.8 mil ion in five years—fast enough to put us on the 1984 Inc. 500 list. We had cash flow problems al the way, but I didn’t focus on them. I was too busy sel ing.
Ask Norm
Dear Norm:
I’ve reached a stage where I need to graduate from using two part-time accountants to having a full-time controller. As I get ready to make the change, I’m wondering what numbers I should be watching on a day-to-day basis.
Gary
Dear Gary:
Every business has its own critical numbers, and my guess is that you already know what yours are. How do you tel whether you’re having a good week or a good month? What happens when your sales drop? How long does it take you to col ect your receivables? Those are al simple, commonsense things. Your financial person should be helping you figure out the numbers you need to be looking at and then providing them to you on a regular basis. When you’re interviewing for your new control er, make sure that he or she is up to the task. If you feel as though you’re a little weak on the numbers, don’t be afraid to say so. Put your questions to the candidates themselves. If they can’t give you answers that make sense, don’t hire them.
—Norm
The whack on the head final y came in the form of a cash crunch that forced me to go without a salary for four straight weeks. Elaine was pretty upset. “What do you mean, you can’t pay yourself?” she said. “I thought business was fabulous. I thought sales were going through the roof. How can you be doing so great, and yet you can’t bring home any money for four weeks? Explain that to me. It doesn’t make sense.”
The truth is, I couldn’t explain it to her because I didn’t understand it myself—but I realized I had better figure it out. Eventual y, I did. What I learned is that you have to look ahead. You have to figure out how you’re going to get the cash required to increase your sales at whatever rate you have in mind. If you don’t, you run the risk of sel ing yourself into a cor
ner. I’m talking about losing control of your situation, about decisions being taken away from you, about being forced to do extreme and unwise things just to stay alive. Going without pay is the least of it. Many people stop paying their withholding taxes, which is not only il egal but stupid. Between interest and penalties, there is no more expensive money in the world. Meanwhile, your creditors are banging on your head because you can’t pay your bil s in an orderly fashion. It’s a nightmare.
So how do you plan for growth? More precisely, how do you determine the amount of additional cash needed to cover new sales? To begin with, you have to ask the right questions about the new business coming in:
1. How much is it, and over what time frame?
2. What’s the gross margin?
3. How much overhead wil you have to add?
4. How long wil you have to wait to get paid?
If you know the answers to those four questions, you can make a rough estimate of how much extra cash you’l need.
I’l give you an example. Let’s suppose you’re anticipating that sales wil increase by $100,000 over the next year. You have a gross margin of 30
percent, and you don’t expect it to change because of the new business, but you know you’l have to add $10,000 in overhead—for commissions, bookkeeping, whatever. You further expect your average turn of receivables (col ection time) to hold steady at, say, sixty days.
Here’s what you do:
Start by figuring out your cost of goods sold (COGS) on the new business—the amount of money you’l have to lay out to produce or acquire whatever you’re sel ing. Since your gross margin is 30 percent of sales, your COGS is 70 percent, or $70,000. Add to that the extra overhead you’re going to need—$10,000—and you get $80,000 in new spending to fil $100,000 in new orders. Divide the total by the number of days in the period covered—in this case, 365—and you find out that the new business is costing you $219.18 per day. If you then multiply that number by the number of days it takes you to col ect your receivables, you get an idea of your additional cash needs. For safety’s sake I always increase the col ection period by 20 percent, so in this example I’d multiply by 72 days instead of 60. The result: 72 days x $219.18 per day = $15,781.
