After the new economy:
The shift from market-based to cost-based pricing
This one is different. The economy normally cycles in a boom and bust pattern that is reasonably predictable. However, this bust trough is unique in its depth and breadth. Businesses that survive this one are going to be adaptable and lean.
After World War II the North American industrial and manufacturing sectors were relatively intact. This allowed a production capability that, coupled with the world’s demand for consumer goods, fostered a buoyant growth market. North America grabbed the proverbial brass ring and reaped the rewards of increasing wealth.
Between 1960 and 2008 the baby boomers and their children provided a steadily increasing demand for goods and services. Japan, Europe, France, Germany, and some Pacific Rim countries rebuilt and increased production to meet this demand.
The development of personal credit and the modification of accounting policy to a Mark-to-Market asset valuation allowed financial markets to lend capital and further stimulate demand; the upward spiral continued. Financial institutions lived in a world that needed future cash flows to continue present economic development. The economy grew at an exponential rate.
Over these years financial institutions retained assets on their balance sheets at the lower of cost or market. If the asset went down in value or if the asset went into default, the banks would hold the asset on their balance sheet at the book value. When the asset increased the banks would value the asset at the higher market value.
Banks also sold mortgages to individuals that did not have the cash flow to service the debt. This spurred the sub-prime market. Some G7 governments deregulated their financial markets and this again encouraged lending. Credit cards were offered to almost anyone and the more risky cardholders were simply charged higher rates to balance their increased risk. The banks would hold any delinquent credit card balances on their balance sheets at book value and the institutions gained equity.
This went along until the second half of 2008 when the price of oil reached $150 per barrel — and the bubble burst. Businesses across the board were not equipped to adjust to the increased cost of goods and services caused by the rising price of oil. Market-driven product pricing meant that businesses could not adjust the price of products and services easily. A significant increase in a key input component causes corporate profits to quickly turn into corporate losses. The stock markets reacted to such losses with a sell-off; the downward spiral continued.
The financial institutions were overextended to the point that they could not float additional loans so the source of new money dried up. The stock markets around the world reacted and the sell-off went global.
The evaporation of wealth in this economic trough has caused consumers to rethink their spending patterns. The decrease in consumer spending worldwide has created a glut in the marketplace. Inventories grow; manufacturers reduce production.
Almost all small-sized to medium-sized businesses have found that the demand for their products and services has declined. There has been a sharp decrease in retirement wealth and a shift from consumer spending on products and services to paying down debt.
The traditional way to weather an economic downturn is to focus on marketing efforts to increase revenues. This economic recession is different because consumers and businesses have almost stopped purchasing. Reduced spending often means that selling prices are reduced again just to generate cash flow. Companies lay off employees or worse, without credit or cash, can not replenish inventories. This is a slow and painful way to slide into bankruptcy.
Reduced spending spiraled the economy downward again. Homeowners borrowed heavily against the perceived market value of their homes. As the value of houses dropped, homeowners found that the home mortgage was greater that the value of their homes. The mortgages were upside-down.
In the years of plenty, many small-sized to medium-sized businesses flourished. Businesses that had found a niche and provided a quality product or service at a competitive price grew to meet the ever-increasing demand. Banks were eager to lend money to growing businesses with a good cash flow and something to use as collateral.
Many once solid companies have suffered a reduced cash flow. Revenues dropped and the value of collateral used to secure loans decreased; loans became essentially unsecured.
The result on the economy was a tightening of bank lending and the drying up of working capital. Businesses continued to lay off workers and reduce the size of their operations; the downward spiral continued.
In the Great Depression of the 1930’s, governments around the world essentially took a laissez-faire attitude and let businesses fail, which is now thought to have prolonged the depression. This time governments are taking a proactive approach. Most financial institutions in G8 countries are receiving bailouts to free up working capital and lending instruments for small-sized to medium-sized businesses as well as individuals.
The US government has reduced interest rates so that cheaper money is available to businesses that qualify for loans. The government is injecting enormous amounts of capital into the economy to bolster confidence and stimulate demand. The managed bankruptcies of General Motors and Chrysler should save these manufacturing icons and many jobs that are directly related. To help homeowners the US government is providing refinancing packages that can be used to right upside-down mortgages.
The government is encouraging entrepreneurs to start new businesses and to expand existing businesses by backing the collateral requirement of conventional lenders with government-backed loans. The SBA loan program has been expanded to help small and medium sized businesses weather this economic storm.
One effect of this recession is that pricing will now be more cost-based. In the past businesses would charge “what the market would bear” and corporate profits were simply the remainder after all the costs and expenses were paid. Even when we come out of this trough, consumers will be much more frugal, basing purchasing decisions on need rather than want. Demand for products and services may not return to the 2008 levels for a long, long time. Perhaps until population growth prompts an increase in demand in new markets.
Businesses need the ability to change directions quickly. The environment that businesses exist in constantly changes, so for businesses to remain competitive they need to change too. In the new economy, businesses must know their input costs and have systems in place to adjust the operations of the company as these input costs fluctuate. This could mean having office personnel work from home or having service vehicles replenished in the field by delivering parts to them. Innovative thinking and acceptance of change will allow businesses to survive and prosper.
The key to changing to meet the new economic reality is knowing what your costs and expenses really are. Small-sized to medium-sized businesses need to create simple but effective financial models to determine that cost and plan their profit. The concept is simple. Create a viable financial model and then put in place a reporting system that provided timely useful feedback to key employees so that they are working together as a team toward a common goal. Without an effective organization and a fiscal control and reporting system your company is operating blind.
Doing nothing and hoping that everything will return to the way it was is not an alternative. It is up to you and your management team to forge a new viable business model for your company.
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