The 30% rule

What I’m going to describe to you is a principle of business strategy, planning and management that will help your organization for many years to come.  It’s not a tool that you can implement today and see the effect tomorrow.  It takes time to design and install. Once enacted, it takes time to produce the results you’ll benefit from.  And it takes discipline to maintain through the sine wave of business cycles.  The rule begins with a few assumptions.  If you agree with the assumptions, you’ll immediately understand why the “30% rule” is advantageous.

The first assumption is that the talent in your company is the only asset you have.  While a corporation has a legal identity that is separate from its constituent human beings, that identity is a hollow shell until a person expends energy within it.  Money might be in the bank.  Patents might be issued in the name of the company.  Buildings and equipment might exist, titled to the corporation.  None of those inanimate assets “do” anything by themselves.  They have to be employed by people.

The second assumption is that losing talented people who have demonstrated their ability to contribute causes both short-term performance damage and long-term risk to the company.  When good people have to leave a company, they take years of investment as well as all their future contributions with them.  So having to reduce strongly performing staff due to a downturn in business is the worst decision any company can make.

A third assumption is that the health of a company is measured, in order of priority, by cash flow, profitability and revenue.  Valuations of companies are tied to the likelihood and magnitude of future cash generation.  The methods might include conventional formulas for establishing market value according to multiples of revenue or profit, discounts due to illiquidity of the equity and minority positions, comparative transactions, etc.  But they all ultimately can be traced back to the expectation of future cash flows.

If you agree with these assumptions, then the goal is to ensure that through both good times and bad, the company is able to 1) retain its performing talent, and 2) maintain positive cash flow.  The common mistake is that during good times, the company leaders allow the business model to change incrementally towards a structure that prevents it from achieving these two objectives during hard times.  So what is the structure that should be maintained?

Here’s where the “30% rule” comes in.  The rule means that the business structure should be designed in order to be able to suffer a 30% drop in business at any time, without requiring staff reductions or losing the ability to generate positive cash flow.  You might say, “Well, that rule wouldn’t have helped us in the current recession, because lots of companies experienced 40-50% revenue cuts”.  You’d be right that a 30% model wouldn’t be sufficient to retain staff at that level of revenue reduction.  But if you design your business around a 50% reduction scenario, you will actually retard its ability to compete and prosper in good times, thus jeopardizing its ability to survive in either condition.  A 50% drop in the economic engine is a less likely event than 10-30%.  If you have a business organized on the 30% rule, you have a much better chance of making the adjustments necessary to quickly address a steeper decline, than those companies who were modeled after an expectation of continued linear growth.  And there are an embarrassingly large number of those examples that we can see in the daily business press over the last several years.

So how do you construct a 30% “drop” business model?  Simply put, you ensure that your operating costs (COGS, direct and indirect labor, overhead, etc.) are comprised of no more than 70% fixed expenses, in every expense category.  That includes materials, labor, facilities, SG&A, insurances, benefits, etc.  Usually, COGS is made up of half fixed (direct labor) and half variable (raw materials, work in process) expenses.  So COGS meets the criterion.  Indirect costs are where the problem usually lies.

For example, on the labor category, you can achieve a higher variable cost component by setting your compensation guidelines that will place your base salaries both by job and in aggregate at, or a little below, the fiftieth percentile of the market ranges.  Then use a profit-funded incentive plan to distribute performance-based bonuses to all employees that would allow them to earn total compensation at the high end of the market in good times, while reducing labor costs in direct proportion to declining revenues in hard times.  Since most companies’ largest single expense is labor, this is a tremendous advantage that allows the company to flex with the times.  And if employees are all included, with education and ongoing transparency of information, most of them will understand the philosophy to be in their best interests.

Another expense factor to focus on is business process efficiency.  If you have a profit sharing plan as described above, most employees will recognize the value of reducing waste of time and resources.  The organization never gets too “fat”.  Raw materials, work in process and finished inventory levels never exceed the optimum usage rate and quality stays high so that scrap and rework is minimal.  This applies equally to manufacturing of products or “manufacturing” of services.  And a third category is facility expense.  Keep the square footage and fixed assets down.  If your average square feet per person is 100, while your competitors’ is 200, you have a 50% cost advantage on that category that can translate to pricing elasticity in more competitive markets.  If your facility practices are designed around feeding egos, you’ll starve during economic downturns.

Taken together, these structural methods can yield higher profitability in good times, and preservation of your only asset…people…during bad times.  Start making the changes necessary now, so that over the next several years you will be able to enjoy the comfort of knowing that you can thrive both at the peak and in the trough.

 

 


 

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