Cashflow and monthly operating costs are key

Wed, 8 Apr 2020

AFTER watching Prime Minister Tan Sri Muhyiddin Yassin’s announcement on the enhanced stimulus package for SMEs, my various chat groups came alive with all kinds of comments and opinions. In particular, one chat group which comprises experienced retired senior bankers, entrepreneurs and senior business journalists (all about the same age of 60 and above) stood out for its wisdom and sharp foresight.

When asked about potential SME casualties in this economic crisis, a senior banker commented, “TH... I went through four deep recessions/business cycles, ie, 1987,1997,2007/8, and now 2019/20. Same like you, and no wiser than my friends in this group.

"My gut feeling is that there will be more casualties this time around because the pandemic is world-wide. But like all recessions, the economy will turn around. It will not likely be a V-shaped recovery. We all have to tighten our belts, cut losses, and make sure we survive to enjoy the recovery.”

He is correct, as this recession is like no other. It is the first time that almost all economic activities have stopped in all the major countries in the world at the same time. There is a supply shock as the supply chain has been completely disrupted to a standstill.

There is demand shock as sales of most industries have fallen off the cliff to almost zero during lockdowns, and there is capital market shock as global stock markets crash.

Predicting the timing of the recovery is extremely difficult as we now have to deal with a virus pandemic with no solution in sight. Yes, a complete lockdown can flatten the curve but the risk of a re-occurrence of a new wave of infections is very high when the movement control order (MCO) is lifted. Economic activities have to resume, so we will have to practise some form of restricted MCO for the next six months.

And this affects business.

Sales will continue to be very soft as consumption drops due to lower consumer confidence, higher unemployment and reduced personal income, as widespread paycuts are implemented. As in most recessions, not all businesses will do badly. From experience, consumers tend to trade down, ie, purchase lower-priced alternatives to sustain their lifestyle. Hawker stalls will continue to do well, while higher-priced restaurants will suffer.

The logical conclusion for SME owners is to focus on surviving the next six months. Once the moratorium on your loans ends in October, will you still be standing with the ability to start repaying them? Will you have sufficient cash flow to participate in the economic recovery which will probably start in 2021?

Your survival strategy till October will have to focus on two key issues - 

• cash flow and 
• monthly operating costs.

Managing cash flow 

> Sufficient banking facilities - Since all your loans have been placed under a moratorium (meaning that you won’t need to repay them for the next six months) by your bank, you will need to check if the balance amount of banking facilities will allow you to trade normally.

If not, quickly apply to your bank for additional trading facilities. If you have spare cash, it might be wise to start paying down your loan when you can and not wait till the end of October.

> Cash reserves - You will need to cover March and April losses from your cash reserves. Reduce your losses for the next five months through aggressive cost-cutting. Most businesses will face delayed collections so cash reserves, if available, will be most useful to cover cash-flow deficits.

> Wage subsidy - Expect delays in your claims as the government will not be able to cope with the massive influx of applications. If approved, expect delayed payments of at least a month in your cash-flow planning. The wage subsidy is only for three months but you need to survive the next six months. So, plan accordingly.

> Corporate tax - For companies that will definitely declare a loss in 2020, my advice is to write in to the Inland Revenue Board informing them that you will declare zero profits for the financial year-end 2020, and suspend all tax payments for future projected profits. There is no point loaning the money back to the government when you need it more to survive.

> Deferred EPF payments - Just like bank loans, EPF payments have been deferred for six months when you will have to restructure your payments with the agreement of the EPF. Do not consider this as savings. It goes into accounts payable, interest-free of course.

> Rental subsidy - The announced tax deduction for rental rebates of 30% for three months from April to June will be effective in encouraging private-sector landlords to implement only if double deduction is allowed. In times of need, business partners should help one another. This is how the Chinese business community has been built over the last 100 years in Malaysia.

This is probably the best Bank Negara strategy to help preserve cash-flow liquidity for businesses to continue trading. By allowing the banking system to prevent classifying non-payments after three months as non-performing loans (NPLs), businesses can breathe and continue trading for another six months. Individuals too have more cash in hand to offset the paycuts that will definitely happen. By end-October, Bank Negara must allow another restructuring of existing loans by another six months to businesses who will benefit from the economic recovery.



Reduce monthly operating expenses.

The survival of your company depends on the amount of cash reserves you have to fund losses in March and April and also losses to be incurred from May to October. So, it is imperative that losses are kept to a minimum in the next five months.

Losses are calculated after deducting expenses from net sales. Net sales is gross sales less cost of sales. So, if net sales are down, expenses must come down proportionately, which in this case might not be possible for companies which suffer a big drop in sales.

While your sales revenue is dependent on external factors which are beyond your control, to a major extent, you are in control of your own expenses. For most service companies, payroll forms the biggest portion of the monthly expense. This is normally followed by rental or in some companies, advertising and promotion.

> Rental - At the maximum, expect your landlord to give you a rebate of 30% from April to June. This means that you can factor into your expenses a reduction of 15% in rental payments for the next six months.

> Advertising and promotion - It has been proven in the last recession that companies that continue advertising and conducting promotional activities will sell more than their competitors who stop completely. You are advised to work with your media suppliers to get more bang for the same budget. I am sure the media companies will support you, as they too need sales and have excess inventory to give away.

> Office expenses, allowances and claims - Cut all the unnecessary frills that you can ill-afford. Not much but every penny counts. Spend some on healthcare, though, to look after the team.

> Wages - I have stopped comparing with the Singapore government’s wage subsidy plan because our government does not have sufficient reserves.

With the latest proposed enhanced wage subsidy, it looks like SME owners must take matters into their own hands. Some companies will enjoy reasonable support of up to 30% subsidy on the wage expense, while some will only enjoy 5% to 10%.

Do remember that this is only for three months. Why the government is not exempting EPF payments for six months is beyond my understanding. This will only translate to a higher paycut across the board.

I have an investee company where the senior management has given the board of directors a revised sales forecast, with sales revenue dropping by 20% against the 2020 budget. But no corresponding reduction in expenses was given.

I have replied that this sales forecast might not be achievable and that we should start looking at reducing our expenses, mainly the payroll, which is a massive portion of it.

I would recommend a minimum 20% paycut across the board, freezing all intakes, probably retrenching a few positions deemed not necessary and linking the paycut to sales. If the sales for May to October drop by more than 50%, then the paycut will be more severe like 30%-40% for those who earn above RM4,000. However, if sales recover to its original budget then the salary will revert to its original amount.

Different companies will have to tailor different strategies, depending on the sales performance of the company up to October. For companies where payroll forms the bulk of expenses, detailed human resource requirements must be considered.

Where possible, the fixed salary cost should be changed to a variable cost, as a percentage of sales. This will help minimise losses to a great degree and at the same time save jobs and keep your key employees employed.

Some form of right-sizing is required now. Where possible, eliminate jobs to reduce 10% of your current payroll. Then undertake a paycut of 20% to make total savings of 30%. Then, submit for wage subsidies to the government if your company qualifies, which will probably save you another 5% to 10% of your existing payroll. With immediate savings of 35% to 40% from payroll deduction, you can take your chances with the remaining five months, of which April is already a complete loss for you.

Then my entrepreneur friend asked, “What if the employee does not accept a paycut?”. My answer: “Nobody can stop this employee from leaving the company on his own free will.”

At this moment of truth, SME owners’ only objective is to save the company from going bust. Minimise the losses so that you can stretch your reserves till October.

At the next moment of truth in October, SME owners will have to decide whether to continue or close their business. Don’t forget that you still have deferred EPF payments and the loans with interest to pay off. You can avoid bankruptcy if your business is still alive in October 2020.

From one battle-scarred entrepreneur to all the young entrepreneurs and SME owners out there: “Stay alive today to fight the next battle tomorrow. And you will win again.”

Views expressed here are the writer’s own.



https://www.thestar.com.my/business/business-news/2020/04/08/cash-flow-and-monthly-operating-costs-are-key

Understanding the importance and implications of Leverage

Importance of Leverage

Leverage increases the volatility of a company's earnings and cash flows, thereby increasing the risk borne by investors in the company.

The more significant the use of leverage by the company, the more risk it is and therefore, the higher the discount rate that must be used to value the company.

A company that is highly leveraged, risks significant losses during economic downturns.



Leveraged is affected by a company's cost structure.

Generally companies incur two types of costs:

• Variable costs: vary with the level of production and sales (e.g., raw materials costs and sales commissions).
• Fixed costs:  remain the same irrespective of the level of production and sales (e.g., depreciation and interest expense).

Conclusion:

The higher the proportion of fixed costs (both operating and financial) in a company's cost structure (higher leverage) the greater the company's earnings volatility.

The greater the degree of leverage for a company, the steeper the slope of the line representing net income.

Leverage

Leverage refers to a company's use of fixed costs in conducting business.

Fixed costs include:

• Operating costs (e.g., rent and depreciation)
• Financial costs (e.g., interest expense)

Absorption Cost

Absorption cost takes account of all costs and allocates them to individual products or cost centers.


Direct or variable costs

Some costs relate directly to a product and this is quite straightforward in principle, although very detailed record-keeping may be necessary.

Among the costs that can be entirely allocated to individual products are

• direct wages and associated employment costs, 
• materials and bought-in components.

Indirect costs

Other costs do not relate to just one product and these must be allocated according to a fair formula.  

These indirect costs must be absorbed by each product.

There is not a single correct method of allocating overhead costs to individual products and it is sometimes right to allocate different costs in different ways.

The aim should be to achieve fairness in each individual case.  

Among the costs that cannot be entirely allocated to individual products are

• indirect wages (cleaners, maintenance staff, etc.), 
• wages of staff such as salesmen and accountants, and 
• general overheads such as rent and business rates.

Take care to allocate non-direct costs fairly

Great care must be taken in deciding the best way to allocate the non-direct costs.

There are many different ways.

The following two are common methods:

1. Production hours
2. Machine hours

Common Methods for allocating non-direct costs fairly

1.   Production hours

The overhead costs are apportioned according to the direct production hours charged to each product or cost center.

For example:

Consider a company with just two products.

Product A having 5,000 hours charged and Product B having 10,000 hours charged.  

If the overhead is $60,000.  Product A will absorb $20,000 and Product B will absorb $40,000.

2.  Machine hours

The principle is the same bt the overhead is allocated according to the number of hours that the machinery has been running.

For example:  

Consider a company that manufactures three types of jam.

Its overhead costs in January are $18,000 and it allocates them in the proportion of direct labour costs.

January Cost Statement

                                    

                                  Strawberry      Raspberry        Apricot         Total

Jars produced              26,000           60,000           87,000           173,000           

                                          $                    $                   $                      $

Costs                        

Direct labour                   2,000            4,000            6,000              12,000

Ingredients                      6,000           11,000          17,000              34,000

Other direct costs            2,000             3,000            6,000              11,000

Total Direct Costs         10,000           18,000         29,000              57,000

Overhead allocation         3,000             6,000           9,000              18,000

Total Cost                      13,000            24,000        38,000              75,000

Cost per jar                    50 sen            40 sen         43.7 sen           43.4 sen  

In the above, the direct labour is smaller than the overhead cost that is being allocated.

The trend in modern manufacturing is for direct costs and particularly direct labour costs, to reduce as a proportion of the total costs.  

If the overheads had been allocated in a different way, perhaps on floor area utilized, then the result would almost certainly not have been the same.

This increases the importance of choosing the fairest method of apportionment

Break-even charts

In nearly all businesses, there is a close correlation between the level of turnover and the profit or loss.

The managers should know that if invoiced sales reach a certain figure the business will break even.

If invoiced sales are above that figure the business will be in profit.

The break-even point depends on the relationship between the fixed and the variable (or direct) costs.


Breakeven chart. 



The break-even point can be calculated by drawing a graph showing how fixed costs, variable costs, total costs and total revenue change with the level of output.


Fixed costs are shown as a flat line in the chart above..

The total costs are the result of adding the variable costs to the fixed costs.

The revenue is the result of sales.

The break-even point is when the total costs line crosses the revenue line.  It is at this point where these lines cross.

Profit and loss can also be read from the chart.

In practice, the relationships are rarely quite so straightforward, as some of the costs may be semi-variable.




More charts:

The uses of costing

It costs time and money to produce costing information and it is only worth doing if the information is put to good use.

The following are some of these uses.

1. To control costs
2. To promote responsibility
3. To aid business decisions
4. To aid decisions on pricing

1.  To control costs

Possession of detailed information about costs is of obvious value in the controlling of those costs.

2.  To promote responsibility

Management theorists agree that power and responsibility should go together, although often they do not do so

Timely and accurate costing information will help top management hold all levels of management responsible for the budgets that they control.

Care should be taken that managers are not held responsible for costs that are not within their control.  This does sometimes happen.

3.  To aid business decisions

Management must decide what to do about the unprofitable product.

4.  To aid decisions on pricing

We live in competitive times and the old 'cost plus' contracts are now virtually never encountered.

What the market will bear is usually the main factor in setting prices.

Nevertheless, detailed knowledge concerning costs is an important factor in determining prices.

Only in exceptional circumstances will managers agree to price goods at below cost.

They will seek to make an acceptable margin over cost.

Accurate costing is vital when tenders are submitted for major contracts and errors can have significant consequences.

Massive costing errors on the Millennium Dome at Greenwich were a spectacular example of what can go wrong.

Marginal Costing: Selling price > Variable or Direct cost ---> part of the Fixed cost is absorbed by the margin.

Marginal costing is a useful way of emphasizing the marginal costs of production and services.

This information is of great help in making pricing decisions.

If the selling price is less than the variable cost (direct cost),

• the loss will increase as more units are sold, and
• managers will only want to do this in very exceptional circumstances, such as a supermarket selling baked beans as a loss leader.

If the selling price is greater than the variable cost,

• then the margin will absorb part of the fixed cost, and,
• after a certain point profits will be made.

Why some goods are sold very cheaply at certain time?

Marginal costing explains why some goods and services are sold very cheaply.

It explains,f or example, why airline tickets are sometimes available at extremely low prices for last-minute purchasers.

• Once an airline is committed to making a flight, an extremely high part of the cost of that flight can properly be regarded as a fixed cost.  The pilot's salary will be the same whether the plane is empty or full.  
• The variable cost (direct cost) is only the complimentary meals and few other items.  
• It therefore makes sense to make last-minute sales of unsold seats at low prices.
• As long as the selling price is greater than the variable cost, a contribution is made (absorbing part of the fixed cost).

A basic understanding of the principles of costing is important in business management.

Most non-financial managers instinctively know that costing is important.

Unfortunately, it is probably also true that most non-financial managers do not know very much about it.

This is a pity because it affects so many business decisions.

For example, the fixed costs of running a cruise ship do not vary (or realistically only vary slightly) according to the number of passengers is the reason that large last-minute price reductions are often available. (Think of that when you book your holiday.)

A basic understanding of the principles of costing is important in business management.

Do not overlook the value of marginal costing

When times are tough there is likely to be pressure on sales and margins.

In this situation, marginal costing could be very helpful.

It may be essential to cut fixed costs and it may be necessary to adjust prices.

Marginal costing should help you make the right decisions.