Preparing for a recession

By Rudi Burkhard and Eli Schragenheim

Recession is an external threat that no organization has the power to stop or even delay.  A recession starts when enough people (those that influence the economy) expect it to happen soon and they start to take action to protect themselves from its impact. These may be actions by politicians, central banks or a major financial scandal that accelerate peoples’ decisions to take action.

What should a company do when recession is a close possibility?

A recession pushes most managers out of their comfort zone.  Managers’ intuition about markets’ direction dives and their fear level surges.  Every organization suffers the reaction of clients and suppliers to the coming recession. The first blow (actions) to sales are often much bigger than the actual real decline of the economy.  The knee jerk reaction is to reduce inventories; suppliers are the first to feel these reactions, sometimes even over-reaction, to the recession’s threats.

It takes time to understand the actual impact of a recession. Until that time hysteria and limited intuition frequently cause major mistakes. Managers also do not have good intuition about a recession’s impact on real physical demand. They often do not understand what really takes place in the economy.

Common practice is to cut cost. Warning: This common practice takes management’s focus away from the one parameter they must not hurt: sales!  To survive a recession a company must, as much as possible, protect sales revenue. We don’t claim that reducing cost is not important or critical to survival, but managers should carefully analyze their situation to ensure they do not disrupt their sales more than the recession  does. They must be careful to not make the recession’s damage worse.

Estimate the impact of a possible X% sales decline

Throughput Accounting, and more recently Throughput Economics, lead to a clear set of data and information that together estimate the range of valid probable results from such a macro-economic event.   Using these two tools, and the related knowledge, can lead to a much better perspective on how a recession might cause damage to the company’s future.

Two financial parameters are of special importance:

1. Total Throughput (T), revenues minus totally variable costs (TVC).
2. Total operating expense (OE) – all the money spent to maintain the necessary capacities of resources (space, equipment, manpower and even cash).

Comment:  The TOC goal measurements include also the money that is captured within the organization, called ‘Investment’ or just ‘I’.  While it is one of the key measurements it seems that to evaluate the potential impact of a recession the part of Investment that is important, is inventory, which is a natural candidate to reduce.

Interested readers are referred to the Theory of Constraints materials on Throughput Accounting, like Thomas Corbett book Throughput Accounting, and the more recent Throughput Economics by Schragenheim, Camp and Surace. These resources explain how the concepts they introduce give much better insights into the current and future financial state of a company.

Throughput is the cash inflow from sales (minus the cost of materials).  OE is the cash outflow to maintain the necessary capacity required to stay in business. Cash inflow includes depreciation of the investment in capacity.  Sufficient capacity is required to support the two key flows:

1. The Flow of Value, focusing on the current flow of products and services to clients. This flow encompasses the entire chain from purchase orders to suppliers to product delivery to clients and finally payment collection.
2. The Flow of Initiatives to improve (increase) the Flow of Value. This flow contains all improvement projects and new idea evaluations for products and processes.

A cost cut reduces capacities; for instance, by stopping all overtime, special shifts and temporary workers production capacity is reduced.  Depending on local regulations the company could also consider lay-offs and/or short workweeks.  Understanding the impact of these actions on sales volumes is critical for the survival of the organization.  Companies should use careful prioritization to prevent from cutting capacities that ensure the Flow of Value is maintained. An unavoidable and longer-lasting decrease in demand makes such cuts possible, as long as delivery lead-times and reliability to remaining clients are not negatively impacted.

Practically this means that when cutting capacity, the cost required to maintain capacity, should be considered mainly for resources required to support the Flow of Initiatives, rather than resources required to maintain the Flow of Value.  Proper consideration reduces the threat to future prosperity by the delay or cancellation of flow initiatives.  This implies that some of the luxuries management gives itself are valid potential cost reductions. Every organization may have capacity that supports the Flow of Value in an indirect way or maybe does not support it at all.  Such capacities with a questionable direct contribution to the business are the natural and sensible candidates to be cut in a recession.

In practice this means considering the short-term benefit from cost cuts vs. the longer-term benefits that will stem from the Flow of Initiatives. Cutting cost that stops or slows the Flow of Initiatives threatens future prosperity and creates opportunities for competitors.  Sometimes the short-term survival dictates having to give up future opportunities, but extra care is needed for that.

The two categories of actions necessary to keep a company safe, even truly successful, over the longer term are:

1. Predict the possible range of the financial impact in order to correctly choose the resources that must remain to provide a good enough financial (cash flow) performance during the recession and enough to best support growth once the recession recedes.
2. Improve Operations to a level so that reaction to market demand changes are faster than any competition. By this the company gains a clear, even decisive, competitive edge. Rapid identification of the products less impacted by the recession is one example how improved operations can be used to gain an advantage over competitors. A recession presents opportunities to capture more market demand; demand that until the recession has been served by competitors. A recession ‘forces’ clients and their suppliers to reduce inventory, which in turn requires a faster response to supply smaller quantities.  The supplier able to respond faster with smaller quantities (replenish his clients at a higher frequency) than the competition gains a decisive advantage.  Spare capacity should be used to accelerate response times, and to keep low stocks of finished goods to maximize the competitive advantage.

Major points to realize when predicting the depth and duration are:

Operating Expense behavior is not linear:  it is impossible to reduce the capacity by the exact predicted decrease in sales. Most resources come in sizable increments. Cutting capacity is possible only in amounts different from that required by the decrease in sales.

Can we make reliable estimates of the extent of reduced demand? Can we make reliable estimates of the extent of price reductions? We cannot!

All decisions are based on forecasts that are mostly intuitive, sometimes quantitative or a combination.  Forecasts are always based on the past with assumptions on how past behavior will change.  Management practice of treating forecasts as deterministic is the core problem behind erratic decisions over demand. A single number will never be reality – the best we can do is estimate a range and prepare to respond quickly as reality becomes clearer.  A valid way is to define a range from the conservative to the optimistic assessment. Both estimates should be reasonable; put aside possible results with a very low probability.

Thus, it is possible to estimate the reasonable range of the impact of the recession on a specific market and then check the extreme predictions to decide what, how much and where to cut cost and how much stock is absolutely necessary.  Note, you need to check both extremes, not just the conservative side. The optimistic side gives you what you might lose if you just consider the worst case.  As the recession’s impact can be quite different for different businesses and for different countries or regions the responsibility of the management of every company is to estimate the reasonable range of change in their specific market.  Estimating a range is easier (not “easy”, just easier) than predicting a single number. The company can discern reasonable estimates of how bad the situation might become and what can be done about it. The company should also consider what it can achieve if it maintains the required level of resources to obtain the best outcome of the recession.  This is the Throughput Economics process to obtain vital and relevant information that support superior decisions and results.

Both the conservative and the optimistic assessments lead to actions.  The job of management is to make the decisions that, even when they are based on the wrong side of the estimates, the damage is limited, while the potential gains are high.

Probably all managers realize that in their market final consumer behavior is critical.  Consumers dictate demand.  Consumers’ demand impacts all players in a supply or value chain. For some value chains or positions in the value chain the recession’s impact may be somewhat delayed.  It is essential that B2B organizations extend their evaluation beyond their immediate clients. In order to predict the evolution of demand they must evaluate what is likely to happen to the demand all along the chain starting from the final consumer.  Suppliers to retail organizations might suffer a very high drop in sales at the beginning of the recession.  However, the real drop in sales to the end consumers is usually much smaller.  Nevertheless the retailers decide to reduce inventories.  For suppliers this means demand is likely to return back quite soon. Understanding clients and their clients’ business well is an essential capability for every organization in a value chain. This capability is not only critical in a recession – it is always a critical competency to understand clients’ needs even better than they do!

How do streamlined operations win in the market during recession?

The Theory of Constraints (TOC) for manufacturing and distribution companies is the ultimate Lean. TOC methods ensure excellent response times and/or product availability with the lowest possible amount of work in process (WIP).  These methods are the correct choice whether in a recession or not.  These methods also require the least amount of cash to finance inventory and operations.  This makes the potential for competitive advantage especially during a recession. During a recession everyone is under pressure to spend money much more carefully.  Every purchase, by an individual or by the organization, is thoroughly checked. Competition becomes fiercer than before opening the path to price competition (price wars). The other, often ignored, option is to compete using faster response and smaller quantities. Throughput Economics and Simplified-Drum-Buffer-Rope (SDBR) are combined to define your best strategy and tactics to deal with an arriving recession.  As inventories are flushed out of the system, once the original demand comes back the suppliers should be ready to deliver, with less inventory, the original demand plus the new demand achieved through fast response during the recession.  Constantly updated holistic information on the actual demand and its trends allows management to estimate when demand will start to rebound. This information is critical to decisions about the required capacity levels, which in turn determine cost and cash flow. The questions to answer are how strongly the company should protect current sales and to what extent should improvement projects continue to be implemented.

The Theory of Constraints (TOC) tools, particularly SDBR and Throughput Economics, support this route, combining operational and financial capabilities.  The idea is to limit the potential damage of a recession, gain competitive advantages and be ready when the economy rebounds to fully capitalize on the acquired competitive edge.