NACD Director’s Monthly / Economic Turmoil Changes Director Focus

We are in an economic upheaval and the oversight that the board provides during this time will influence the company for years ahead. We as board members need to be active in helping management focus on the opportunity that this market crisis brings beyond our normal oversight of budgetary review, cost containment, business strategy, etc.

Usually in an upheaval people get a “bunker” mentality and become defensive. Our role is to motivate the company to look across a wide range of topics from product development, market share growth, talent top-grading, cost management, and review of the full range of risks.

We need to focus on the risks that are the most likely ones to impact our businesses, and the areas where we can drive the biggest long-term returns. We must look forward for efficiencies, and focus on the cost of goods sold (COGS).

Drive Cost Efficiency

Traditionally, management and boards look at cutting costs in market slowdowns. Rather than taking costs out of general and administrative (G&A) funds, cost trimming is most effective if we focus on identifying cost reductions that may be within the COGS. Companies that trim and improve their operational efficiency yield longer lasting financial results, positioning the company to be stronger. Companies should:

  • Review and edit low margin stock keeping units (SKUs)
  • Be creative in pricing models to generate additional revenue
  • Develop joint business/marketing agreements for cost effective incremental revenue
  • Work with vendors to share future inventory needs, thereby allowing them to plan and capture efficiencies that can benefit you both
  • Create longer term contracts in inventory.

A key way for companies to save on COGS is to get rid of the unprofitable products. It’s important to look at the “total costs of capital” when calculating the profitability of each SKU. Oftentimes, cost accounting systems don’t capture capital costs, and less profitable SKU’s end up staying in the product line when they should not. Now that capital is not readily accessible and very expensive, companies should definitely look at the “cost of capital” when they review their SKU’s.

Preserve Investment Areas

Companies must continue to invest in the growth areas for their future. It is a mistake to take a numerical approach and cut all capital expenses as a percentage across all areas, or to decide to defer capital projects. A better approach is to decide what are the differentiated unique growth initiatives for the company, and exempt those projects from budget cuts. Companies need to look at a budget review with two things in mind: cost savings opportunities, and future growth initiatives.

Investors expect well-run companies to continue to perform (versus their competition), even in a downturn. Companies need to communicate to the investors that they are going to continue investing in differentiated strategic projects that are unique innovations for the company’s future. The board needs to encourage management to be long term, not only short term. The board can encourage management to identify the “business owners” of the projects who will then determine the tradeoffs within their budget, to drive results for the best return. Companies that invest effectively in growth and future innovation need to encourage innovative thinking in all company functions, including marketing, manufacturing, procurement, and IT, and not just within the R&D group. Fostering a culture within the company to create differentiated and uniquely valuable products and services will keep employees motivated through a downturn for a positive future.

Conserve Cash

Cash is tight now for both companies and their customers. Companies need to be thoughtful and come up with new offerings that may allow customers the ability to purchase a product or service in smaller increments. The customer may be willing to pay slightly more up front, or per unit, in order to purchase a smaller quantity or size of the total order. Customers may also be willing to pay a premium for their product or service if the company has a long track record of being very reliable, or able to guarantee supply.

This same concept applies to how companies can con- serve their cash in working with their suppliers. Pushing suppliers to continue supplying inventory in smaller quantities rather than consuming a company’s cash too quickly will be key in this time of tight credit.

Check Contracts for Honey Pots

Boards should encourage management to have an open discussion in the leadership team, and reach a consensus on what key risks could impact the business. There may be a range of differing views within management on where the risks lie, as well as appetite levels to take on risk.

Opportunities come out of economic downturns. A company with a strong balance sheet might use its cash to lower their prices and capture market share, or offer financing for clients that competitors cannot offer. The risks from suppliers as well as business partners can be addressed by broadening the number of vendors or partners. Procurement and legal functions are areas that may provide management with some positive opportunities in this downturn by providing careful review of contracts to see if there are any terms or covenants that are now enforceable that the company may want to use to their advantage. For example, sometimes contracts that are no longer deemed beneficial can be voided due to credit ratings, debt covenants, or inability to raise capital. A careful review of the company’s current, past, and future contracts may identify pockets of opportunity.

The board needs to encourage management to be vigilant on ethics and compliance in economic downturns. Incidents of internal theft, fraud, and insider trading typically rise in tough times. Management may wish to get out in front of this, and reinforce their policies.

Pay the Performers

This market downturn creates an outstanding opportunity for top-grade talent. There is more talent available out in the market and more importantly, often the best talent, which was not looking, is now recruitable. Boards should actively request management to carefully review their leadership team, and trade up their middle per- formers. This is a great time to find scarce skills if the company can offer a persuasive picture of their future.

Recognition and compensation for outstanding per- formers must continue in tough times. The instinct may be to cut compensation across the board, and this is a huge mistake. The shareholders’ interests are always served when the high performers are rewarded. There is an enormous difference in the results that great performers contribute, versus average performers. Employees all know who the star performers are, and they will be motivated to see recognition and rewards for top contributors.

Compensation committees do need to be thoughtful and make sure that their pay plans are clear and trans- parent, and easily understood by the shareholders. The pay plans should be aligned long term with shareholder interests, i.e. total shareholder return, market share, and other metrics versus shorter term earnings-per-share-only reward systems. The best compensation committees com- pare their executives against peer groups, and look at each piece of the pay package—base, bonus, and equity— and annually review their compensation philosophy. This year, special programs may be needed such as a CEO discretional equity pool to get through these tough times.

The management team that successfully works together identifying crisp plans to lead the company forward, and capturing new competitive opportunities, will have gained unique experience in working through a market down- turn. The highest potential managers will shine, and the team will have sharpened its decision making and business judgment capabilities.

Keeping the morale high and management focused on the important priorities of balancing costs against future growth opportunities is a key role for the board to deliver the right results for the shareholders.

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