Fred stared at the ceiling, then at the clock on his bedside table. It read 3:26 am. His recent concerns over the dire financial condition of his family business haunted him day and night, even in his dreams.
Ten years ago, Fred assumed control of the family business from his father, the founder. Fred had experienced periods of financial stress before, but nothing compared to the burdens now pressing down upon him. This time is different. Solutions seem elusive and Fred is losing confidence in his ability to deal with the challenges created by a rapidly eroding cash flow. How did it get this bad?
A year ago, Fred made a decision to pursue rapid sales growth as his company had experienced slow, but profitable, sales growth for many years. He decided to pursue larger accounts and cut prices to win the business from established competitors. Sales grew as projected. Profits did not. Cash flow turned negative.
Fred missed a critical element of the scale effects of his pricing decision on gross margin dollars. He failed to grasp the magnitude of sales growth necessary to offset the margin dollar reduction resulting from discounting and the impact of variable costs associated with increased production volume.
Given the existing gross margin, a 10% drop in pricing required a 45% growth in sales merely to achieve the same gross margin dollars.
Fred and his team predicted cost reductions associated with increased production volume that were not being achieved owing to high variable costs.
Every business has scale effects (macro, product, service, resource) that have compelling impacts on the financial performance of the business model. The financial dynamics of scale effects can be exploited to increase profitability or may quickly create financial stress.
How does Fred lead his company back to profitability? First, he must understand the financial dynamics of his business model.
