Surviving explosive growth.

Sales are booming--so why are profits sagging?

The company president looks up wearily from his cluttered desk and says to the chief financial officer (CFO), "I don't get it. Sales are booming. Each year we see gains of 25% to 35%. We're three years old and already we're the darling of our industry. So--how come we're not making more profit?"

Such a conversation, or one very much like it, is not that unusual at fast-growth companies. Most entrepreneurs know that success is elusive in the early years, but few realize the danger when revenues soar suddenly. This article examines the symptoms of dangerous corporate growth and offers remedies that accountants can prescribe to their clients or employers.

ORGANIZATION STRUCTURE

Companies undergoing explosive growth often have flat organizational structures. For example, it's not uncommon for the company president to have direct control over 10 or even 20 employees. Everyone reports directly to the company head--sales, marketing, purchasing, finance and accounting, warehouse, manufacturing, shipping, receiving, human resources. As a result, the president becomes a major decision bottleneck.

Procedures that worked well when annual sales were $10 million break down when sales suddenly explode tenfold. Crucial decisions stagnate in endless bottlenecks waiting for one overloaded manager with authority to focus and act.

A case in point: The CFO of one fast-growing company allowed accumulated compensating bank balances to balloon to $3 million more than the agreed minimum. It wasn't because the CFO was incompetent or neglectful; he simply was overloaded and had failed to delegate this responsibility.

The first step to take to remedy the problem is to reorganize management into a conventional pyramid--one in which management responsibilities are delegated to second- and possibly third-tier managers. That single step gives the president time to think, plan, oversee and advise--which is what the top manager should be doing. On paper, the solution looks simple, but getting people to buy into it can be difficult.

If it's so good for the business, why do so many people resist such a change? The first obstacle is the boss. He built the company from scratch. The management structure during that successful period was simple: everyone reported to him. The question now is: Can he get his ego out of the way and recognize that, although he may have been the reason for the business's initial success, now he's overcommitted and has become the cause of chaos? If he can't, such a company--even if sales continue to soar--may collapse into bankruptcy.

If a company can get past that initial obstacle, it's ready to tackle the second one: resistance from middle management. In a fast-growth company with one line of reporting, that may include nearly everyone in the company. Most managers will resist suddenly reporting to a second-or third-level manager, viewing withdrawal of their once free access to the president as a demotion. Overcoming their objections will take time and patience. Top management must understand that their stated objections may camouflage their real concern--which is loss of direct access to the boss.

STAFF QUALIFICATIONS

People don't always grow at the same pace or in the same direction that a business grows. Too often loyal managers who started with the company are given duties beyond their skills and experience in the hope that they will grow into their new jobs. But if they are overworked, they may not have the time or energy to learn new skills. To close this gap, management must more rigorously evaluate key players, assessing their professional credentials and experience. If employees are found to lack the skills needed to function in new jobs, management must either offer training programs to bring them up to speed or move them out.

In addition, it's important that every critical job has a backup person. Management should use these questions to determine the effectiveness of a backup program:

* How often do the backup people fill in to keep in practice and on top of changes in the job procedures?

* To what extent are they cross-trained?

* Who does the fill-in's job when the backup person is called to duty?

FINANCE AND AUDITING

One sign a company is heading for trouble: When the finance department provides management with loads of raw data rather than information that's been interpreted so it's useful to top management. Without that, busy managers are forced to invest precious time figuring out what the raw data mean.

A case in point: The finance department issues a daily profit margin report to manufacturing and sales executives listing all 50 company products. Few, if any, of the managers have the time to translate the data into useful information.

An example of a better report--one that truly delivers useful information and probably takes no longer to provide--is an exception report that cites only those items (if any) that have fallen below established profit margin minimum.

Here are some tip-offs that the finance department is not properly doing its duty:

* Management letters from the auditors are ignored.

* Financial statements and management reports are inaccurate, not timely or not done at all.

* Bank accounts are not reconciled in a timely way.

* Product profit margins are estimates.

One way to help manage explosive growth is to install a balanced performance measurement system. (For more on this subject, see "A Smarter Way to Run a Business," JofA, Jan. 97, page 48.) This is simply a scorecard that employs three steps:

1. Identify the key measurements needed to monitor the enterprise's overall business (production output, sales, inventory turnover, raw material costs).

2. Develop a process for routinely comparing key process measures (such as production output) and results measures (such as return on investment) against the previously established benchmarks.

3. Set up a routine decision-making process for acting on information produced by the performance measurement system to make any necessary midcourse corrections of strategy.

Such a scorecard system places the accounting and management reporting departments where they belong--smack in the middle of the information flow needed to guide the company

SALES SYMPTOMS TO MONITOR

When the sales staff is overworked and undermotivated, the evidence can be found in the customer complaint file--if anyone has the time to compile one.

The basic problems: Do salespeople share their company's good fortunes--that is, is their compensation linked to their results? Equally important, does the sales staff get guidance on which products and services are more profitable to the company than others? In many fast-growing businesses, the answer to both questions is no. One solution: Management should set higher commission rates for more profitable products to reflect the strategy for meeting profit margin targets.

Customer credit is another area that explosive growth companies tend to ignore. Such businesses, by their nature, are aggressive. But often companies forget that bad-debt totals that are too low can be as troublesome as too much bad debt. Unnecessarily restrictive credit policies in effect leave money on the table that could enhance overall profit even after allowance for a slightly increased bad-debt expense.

Next, management must determine who makes credit decisions. Sometimes the same people who once made $2,500 credit decisions now make $250,000 decisions--and often they use the same criteria and methods. Questions to ask:

* Is there a credit policy and a formal credit review committee?

* Is there a written credit authority hierarchy to establish clearly defined credit-granting authority limits for specific individuals?

* Does the company make credit decisions on the fly? Such informal decisions often circumvent established policy because there is simply no time.

* Are the wrong people (such as commissioned sales staff) a part of the credit-granting decision? The head of sales should be a nonvoting member of the credit policy committee. While the committee needs this person's market savvy, recognize that sales people have a bias for giving high credit as an inducement to sales.

INVENTORY CONTROL

Few things eat up precious working capital faster than slow-moving inventory. Management must determine the number of inventory turns; are the cycles sufficient to maximize investment in working capital? This should be handled by relating inventory turns to the turnover of accounts payable and accounts receivable. Many explosive growth companies are cash poor so they must turn their receivables faster than their payables. A well-managed fast-growth company first sells inventory and then collects from customers before actually paying suppliers.

Returned merchandise is another opportunity to grow without financial pain. Returned merchandise requires quick shipment back to the manufacturer for debit to accounts payable.

Does a real-time computer link exist between the perpetual inventory system and the order-entry system? Often fast-growing businesses fail to establish this link. If the inventory and the sales order listings are not equal (and the difference is not due to late-entered sales), there's a problem. Without this vital link, the sales staff cannot know what is available to sell.

Management also needs to assess the adequacy of the inventory back-order system. Fast-growth companies usually experience an increase in back-ordered merchandise. An effective automated order system ensures that inventory is truly out of stock. This prevents needless waste of working capital by ordering items already on hand or in transit from suppliers.

Characteristics to look for when assessing the adequacy of the back-order system:

* Automatically notifies buyers of the need to reorder specific items. Some systems even cut purchase orders automatically.

* Accurately tracks order status and arrival times.

* Allocates inventory to the proper customer orders.

* Interfaces with inventory and sales-order-entry systems. This is necessary to track back-order status and tell which sales orders were indeed back-ordered.

WAREHOUSE OPERATIONS

Managers should walk through the warehouse. The stresses and strains of explosive growth usually are obvious: racks groaning under the weight of overstocked merchandise; stockpiles of similar items scattered throughout the warehouse; lack of a specific location for processing returned merchandise.

Often the warehouse is so busy that the personnel simply don't have time for such housekeeping. However, those are the things that allow a warehouse to contribute to overall profit.

The high-tech systems for modern warehouses sometimes get ignored as managers who started with the enterprise when it was small now lack the time to keep up with innovations. Some modern enhancements that might help include

* Automated inventory-tracking systems that control cycle counts and tell workers where specific items are stored.

* Barcode scanners with remote radio frequency computer uplinks for use on the warehouse floor that tell stock pickers the location of specific items.

* Picking and put-away scheduling systems that optimize warehouse travel routing and improve productivity.

Reviewing the labor expense for the warehouse, including overtime costs, is a must. Explosive growth companies tend to automatically throw more people at problems because they think they can afford it. Determining whether the warehouse runs the proper number of shifts, identifying peak staff demand and comparing that with the number of people actually on the warehouse floor at that time are key steps. Often simply changing the timing of a shift or overlapping shifts during periods of peak demand offers a more cost-effective solution than additional overtime.

Sometimes companies are just too busy to look at shipping details. Freight discount is often one area that suffers in this way. Many fast-growth companies fail to realize that, with their sudden clout, they can negotiate deeply discounted freight rates. Often they blindly pass on the entire discount to their customers. That's a mistake for two reasons:

* Customers may not understand or appreciate this gesture, so there is no marketing advantage in passing along the discount.

* The company is squeezing its own profit margin.

PURCHASING KNOW-HOW

Companies caught up in extremely competitive markets often make their profits on the purchasing side. But during periods of rapid expansion, management's attention sometimes focuses exclusively on doing the deal and getting the best price. Maintaining profit margins takes a back seat. Top managers should see if this is not the case by looking at the overall inventory purchasing discipline to find out whether

* Someone studies demand cycles to make sure sufficient (but not excessive) inventories are in stock at the right time.

* The purchasing discipline includes a computation to determine the most economic order quantities.

Explosive growth companies are afraid of running out of stock and not making that next sale. Some take extraordinary measures to ensure that does not happen. Consequently, safety stock balloons.

More evidence of purchasing problems is panic buying--buying that circumvents normal purchasing procedures or requires extraordinary measures to complete. Panic buying usually indicates that purchasing systems may not have caught up with suddenly exploding product demand. The result is frenzied buying that

* Fails to take advantage of quantity discounts.

* Increases freight delivery costs when buyers too often say, "We must have it--get it here whatever way is fastest."

It's dangerous for a company to have just one vendor for critical supplies: If something happens to that vendor, the company could be in deep trouble. But it also takes time to develop backup vendors. Since purchasing agents at fast-growth companies are under extreme pressure to negotiate deals, track purchase orders and manage the back-order system, they rarely have the time to qualify new vendors. Nevertheless, this is a very important task.

WORKING CAPITAL MANAGEMENT

The most obvious symptom of corporate treasury problems is an excessive number of bank accounts. Dormant accounts may contain significant balances the business could use elsewhere. Further, they require precious time to reconcile each month, so it makes sense to consolidate the accounts.

When looking at the yields on short-term investment of excess cash, it's not uncommon to find funds invested at below-market rates or large balances constantly stuck in overnight instruments (such as repurchase agreements). Such funds can be applied more profitably--for example, by repaying part of the outstanding line of credit.

Also, management should take a close look at the bank the company uses. Organizations undergoing explosive growth may have already outgrown their present banks' capabilities--and that may actually hinder operations. For the questions to ask the bank to see whether it meets company needs, see the sidebar, "What to Ask the Bank," page 70.

Internal cash controls take precious time to maintain. When there is already too much to do, busy staffers sometimes ignore control procedures. Management must watch for compliance with cash control policies such as

* Reviewing and signing off on bank account reconciliations.

* Independent approval of short-term investments.

* Independent reconciliation of brokerage statements.

* Sending brokerage confirmations of investments directly to an independent person within the company.

Watch for the surprise arrival of large cash receipts or disbursement demands. Do this by comparing the cash flow forecast (every growing company should have one) against actual cash inflow and disbursements for several time periods. Sooner or later a cash flow surprise will force the company to take out an emergency loan at inflated rates. Or it can put a company in a position where cash received is underemployed. The result is the yield on liquid assets is not maximized. All are costly and wasteful.

COMPUTER RESOURCES

One sure sign that a company's needs have outstripped its computer resources is the proliferation of standalone systems--those running independently of the corporate network. Explosive growth companies tend to stretch their computer resources, and system degradation or outright crashes are common.

What to do?

Begin by assessing the adequacy of routine data backup and recovery procedures. Although most companies back up data, during time crunches they may neglect testing those routines by staging an actual recovery using the backed-up data to see whether the procedure really works.

The software versions the company uses--which must be examined--should be recent, if not the latest, versions. Fast-growth companies sometimes are too busy to stay current with new updates. Instead, some try patching customized solutions into canned packages as a short-term fix. However, such fixes often create problems because the more extensive this customization, the more difficult it is to convert to the next generation of software.

MANAGEMENT DECISIONS

Explosive-growth companies can be so single-minded about growth that they frequently take on additional business simply because it's there--failing to consider the impact on profit margins, working capital and cash requirements. Growth simply for its own sake--rather than profit--becomes obsessive.

Another clue that swift growth has overburdened management is uncharacteristic hesitation to make decisions--often referred to as analysis paralysis. The philosophy may seem to be better the devil we know than one we don't. While foot-dragging is never good even under normal circumstances, during explosive growth, it can be fatal.

Recognizing the symptoms associated with rapid growth and knowing what to do about them make accounting professionals all the more valuable to their clients and employers. Managers not overwhelmed by one urgent crisis after another can effectively help calm the rocky course of expansion.

RELATIVE ARTICLE: EXECUTIVE SUMMARY

* MOST ENTREPRENEURS KNOW that success is elusive in the early years, but few realize how dangerous it is when success comes suddenly and explosively.

* THE UNDERLYING PROBLEM for such companies it its organizational structures: Everybody reports to the boos. The solution: Create a competent middle management level.

* ONE SIGN OF TROUBLE is a finance department that provides management with loads of raw data rather than useful information. An example of a better solution: an exception report showing only the items (if any) falling below established profit margin minimums.

* FAST-GROWING COMPANIES are aggressive by nature. But often they forget excessively low bad debt can be as troublesome as bad debt that's too high. Unnecessarily restrictive credit policies leave money on the table that could enhance overall profit even after allowance for a slightly increased bad-debt expense.

* FEW THINGS EAT UP PRECIOUS working capital faster than slow-moving inventory. Determining whether inventory turns over sufficiently to maximize the investment in working capital can be done. Do this by relating inventory turns to the turnover of accounts payable and accounts receivable.

RELATED ARTICLE: When Everyone Reports to One Boss, These Problems Surface

Problems that typically occur when a company has a flat organizational reporting structure:

* Unrelated duties are delegated to inappropriate departments or individuals. This often occurs when one person or a department fails at the job so the task is transferred to someone who can do it--regardless of appropriateness.

* Because everyone is so rushed keeping up with the expansion, internal controls are compromised--leading to errors and inviting fraud.

* With the staff juggling too much, workloads gets unbalanced, often resulting in excessive, and expensive, overtime or worse: more errors and lapses in judgment.

RELATED ARTICLE: What to Ask the Bank

Ask a bank these questions to find out whether it really serves the needs of a fast-growing business. Does the bank

* Have sufficient capital to accommodate suddenly increased financing requirements?

* Offer automated treasury workstations that reduce the workload of the cash manager?

* Have automated cash transfers, electronic data interface and electronic funds transfer services?

* Provide a choice of receiving an invoice and paying directly for services or does it insist on payment through earned credit on compensating balances through account analysis?

* Have lock boxes with appropriate and frequent pick-up times?

RELATED ARTICLE: Keeping Your Company Vision at 20/20

During periods of rapid growth, overworked executives often overlook the company's long-term vision. Instead, they merely react to daily crises. It's critical that management review specific performance statistics at least monthly. Such a review should include

* Complete financial statements.

* Cash and working capital sufficiency

* Actual results compared with budget.

* Profit margins by product.

* Sales statistics compared with targets.

* Personnel and staffing needs.

* Credit limits.

* Purchase trends.

* Product availability.

CHRIS MALBURG, CPA, of Palos Verdes Estates, California, consults for organizations undergoing explosive growth. His e-mail address is [e-mail].