GROWTH SECRETS: Creating robust margins

One of the biggest impediments to growth is access to finance to fuel the investments needed to support growth. A business which is in a steady state and makes a reasonable profit will have set aside a certain amount to fund its working capital requirements.

The fortunate business which is able to obtain credit terms from its suppliers longer than the credit terms (if any) it offers to its customers may be able to have a zero working capital position. However, once the firm has to invest in growth infrastructure, the only firms which can do this from internally generated activities are those with high contribution margins. The rest have to raise the funds through the sale of equity and/or borrow funds.

This is a simplistic view of growth as there are normally some economies of scale in staff numbers as the firm engages specialists and the span of control increases. Also firms spend progressively more on productivity assets and processes to gain better use of staff time. However, leaving those considerations aside for the moment, the example demonstrates some significant aspects of growth.

• The amount of data the firm has to process goes up considerably with the number of transactions, often requiring investments in new support systems (financial, logistics, quality control, human resources, customer relationship management, asset tracking, complaints handling and so on). Not only is the firm required to purchase new systems but it must convert data and retrain staff on the new systems.

• Multiple products increase the complexity of operations throughout the business. This applies to R&D, purchasing, operations, warehousing, sales and servicing. Each product will have its own product cycles of innovation requiring re-engineering of plant and new sales and marketing programs. Sales and support staff now have to be trained across more products increasing the training time for each person.

• The introduction of new locations greatly increases the management complexity. New reporting systems need to be introduced involving new target setting, key performance indicators, performance reviews, budgets and exception reporting.

• Increasing numbers of executives puts a strain on management as each new executive needs to be made familiar with the firm’s operations, its policies, reporting systems, products and markets. At the same time, the culture of the business which helps to make decision-making somewhat easier, needs to be conveyed to new executives, often across multiple sites.

• The biggest problem is the sheer rate of recruitment. With a reasonable level of retention, even the best of firms will have problems recruiting at the rate needed to maintain quality and culture. More and more time of senior staff will be taken up with recruitment interviews. New people will need to be trained thus taking up the time of existing employees as well as costing the business the salaries and overheads of new employees before they can become productive.

• New people need accommodation and support systems. Thus the business is in a constant scramble to find new office space and to equip staff with computers, furniture and telephones. Factory and warehouse workers need space to work, equipment to work with and space to store components, work in progress and finished goods inventory. Many staff need car spaces. Staff need to be supported by professionals in training and staff benefits.

Operations need to be supported by staff coverage during sickness and vacation periods.

Many costs during the dizzy process of growth are not linear. Office space can’t be grown one person at a time and telephone systems come in networks of limited sizes which need to be replaced entirely when they reach their technical limits. Factories and warehouses can only be expanded to a certain limit before they need to be duplicated or replaced.

This entire growth infrastructure is an investment. It is either going to have to be funded by the surplus generated by current sales, the issue of equity or debt finance. Equity funding, while avoiding the liquidity risk of repayment, still must see a return on the investment. This has to come from a dividend stream or increases in capital appreciation. If new equity is constantly being released onto the market, capital appreciation is difficult to achieve and shareholders want to see dividends. However the business needs the cash used to pay dividends to fund growth. A catch 22!

The debt factor

Debt is an obvious candidate for sourcing this investment funding. Debt funding may, however, be difficult to secure in new ventures with uncertain markets and low fixed asset platforms. Also debt funding requires servicing which will use up cash. Ultimately of course, loans need to be repaid, which is not a problem providing it can be continually refinanced.

The only successful way out of the growth trap is to generate the investment funds from current sales. The only way to achieve this is to produce generous gross margins on sales. It is the surplus cash generated from current sales which typically fuels the growing business. Thus it is almost an imperative for rapid growth that the firm generates significant cash surpluses both to fund new investments but also to service increasing levels of debt.

High gross margins provide other benefits to the firm. Few growth businesses are able to maintain constant growth. Sooner or later, the firm will incur either internal problems associated with co-coordinating its growth or will suffer a setback in the market. While some problems might be able to be forecast, it is anticipated that most will not. Unfortunately, the disruption will often come at a time when the investment to support the next level of growth will already have been made and committed. However, the resultant income won’t be sufficient to support the new cost level. Without the generous margins generated from current sales, the business would quickly move to an insolvent position and either have to drastically cut back or have to sell out. It is high margins which allow businesses to make mistakes and recover from them.

Absorbing mistakes

This ability to absorb mistakes can also be seen as an ability to buy time. Rather than have to instantly cut back or take drastic action, the firm with a cash buffer can take time out to review the issues, change direction or take corrective action and come back into the market with a renewed approach. While it might have lost some impetus, it is not put out of business. Premium pricing associated with high margins provides the firm with a price buffer in the event of a competitive attack.

The high price and generous margins allows the firm to use its surplus cash to counter aggressive marketing, meet competitive product changes or fight out a price war. Unless the competitor has an equally large war chest to fight with, the firm with high margins can better withstand a competitive attack. In the worst case, the firm will end up with lower prices and a slower growth rate, but will survive.

Healthy surpluses on trading can also allow a firm to invest higher amounts in R&D than its less endowed competitors. This, in some cases, can allow the firm to move ahead more quickly in bringing new innovations to market thus increasing its lead in the sector.

High growth firms tend to have products which are not price sensitive. This usually comes from high product differentiation and servicing a high compelling need to buy. However, not all will have this advantage. Others achieve growth through lower costs, thus generating better margins than their competitors. The increased margins allow them to innovate more, pay better salaries and thus attract higher quality staff, increase their marketing spend per unit of output and attract a lower cost of capital.

While costs may be decreased by finding an attractive lower cost of input, say through off shore manufacturing, most cost advantages come from better processes. These could be associated with better information technology, better management or better operations productivity.

Where sales are somewhat insensitive to price, it is worth investigating the impact of sales at different price levels. Increased margins can sometimes come from increasing profits while decreasing unit volumes. Consumers’ perception of value is not always associated just with utility. In many cases quality is associated with price, thus a high priced item may convey an impression of higher quality or a means of enhancing self-image.

Tom McKaskill is a successful global serial entrepreneur, educator and author who is a world acknowledged authority on exit strategies and the former Richard Pratt Professor of Entrepreneurship, Australian Graduate School of Entrepreneurship, Swinburne University of Technology, Melbourne, Australia. A series of free eBooks for entrepreneurs and angel and VC investors can be found at his site here.