Question:

Dear 80/20 Mentor,

We’ve got a great business and have enjoyed great growth over the last year and a half. We are now seeing slowing orders and backlog is down roughly 20%. Losing this much business will put us in the red. I know I need to reduce overhead and I’m wondering what you’ve seen as a best practice. I’m evaluating a few different options:

Option 1: Halt 401K Program, Cut Bonuses, ask the Management team to take a 10% salary reduction. I’m thinking this will allow us to not have a RIF and we’ll all be in the boat together.

Option 2: Ask each department to reduce headcount and associated cost by 10% across the board.

Option 3: Wait six months to see if orders increase before acting.

Would love to hear any advice you might offer.

Sincerely,

At a Loss

Answer:

Dear At a Loss,

The problem you have is one that all businesses have at one time or another. Here are a few thoughts.

First, let's dismiss option three (waiting six months). While we don't want to overreact and whipsaw our business back and forth (both are bad for culture), six months is too long to wait. A month? Probably too hasty unless it's clear that economic factors make conditions more than a "one-off." Two bad months, and for sure no more than three months is an appropriate period of assessment.

Now, let's assume we do have a downturn that will continue. What then?

Never, ever, do option one (salary/benefits reductions).

Experience proves that your best people are only interested in being in the same boat as other great people.

Cut the pay and benefits of your best people, and they'll look to find better options, leaving you with only mediocrity.

Typically, if a RIF is required, it pays to cut a little deeper so that you can afford to improve the compensation of your best people, reassuring them and making them stick. This a very good practice.

So do we do option two (across-the-board cuts)? No, this is suboptimal as well. 10% across the board will almost assuredly guarantee that you cut too deeply in some areas, and not deep enough in others.

Perform a Zero Up

The best practice is to do a "zero up" of the business and reassess the company's position holistically. A "zero up" allows you to systematically assess and determine what the core of the business is in this new economy.

Start with a clean sheet of paper, and find the silver lining in this dark cloud. It's simple: Identify the most important customers, products, and people, and assemble a pro forma P&L around it. Using 80/20 data, your "Quad 1" (top customers who buy your most profitable products) is a great place to start. See what a pro forma P&L around that tells you. Likely, it will tell you to do some pruning...of customers, products, and, yes, some people and facilities. But, when you're done, you'll have sized the business correctly by reducing costs and complexity both in the right place, and the right amount.

Reverse Engineer the Strategex Key Ratio

Another good practice is to reverse engineer the Strategex Key Ratio. Reverse-engineering the Key Ratio will give you a tactical path to get to your goal. The exercise allows you thus to find a balance of the three levers: growth, price, and cost.

The Strategex Key Ratio—material margin dollars per total employee cost dollars—should be calculated for the last good quarter you experienced. Once you have that number (your goal), compare it to today's Key Ratio (experienced in the downturn), and the pro forma Key Ratio that results after the zero up. If the post-zero-up Key Ratio comes up short, it should inspire you to take another look, and see how much more work needs to be done in order to get to the pre-downturn key ratio. Often, this simple check will be enough to make sure you've thought deeply enough.

Learn More About the Strategex Key Ratio

Tip: Calculate your Key Ratio for the ENTIRE company...don't do it for segments of the company because lots of costs are tied up in corporate overhead. Do the whole company, all divisions, and all costs, in one bucket, and see what it tells you.

Usually, reverse engineering the Key Ratio will confirm what you have!

-The 80/20 Mentor

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