Nov 13, 2024 | Branding, Innovation, Strategy
One of the five costs in your business, in most cases, under recognised, under managed, and misunderstood, is Opportunity cost.
Doing A, means we cannot do B.
It is not always such a binary choice.
Opportunity cost is impossible to calculate with any precision, as it is forecasting the outcome of something you did not do, an opportunity forgone. It is however a critical component of any consideration of the manner in which the available capital of a business is deployed.
It is also driven by the strategy, which is another calculation of the shape of the future, and how you can optimise the leverage your resources deliver.
Commonly used models like discounted cash flows and the more demanding internal rate of return calculations are commonly used by accountants to make the choices between differing capital allocation options. Unfortunately, they both rely on cash forecasts, which are at best fragile. When the strategy calls for ‘innovation’ cash forecasts are usually over-optimistic, and the timing is wrong, so that beyond a ‘pin the tale on the donkey’ analysis, often grossly misleading. Such techniques favour doing more of the same, with at best incremental improvements. Deploying capital towards riskier uses means these calculations are less and less valid, putting off the risk averse amongst management, which is most of them.
We have a fantastic example facing us right now.
Intel used to be the dominating producer of semiconductors. ‘Intel inside’ remains one of the best known and respected brands around, and yet, Intel has fallen radically from grace.
Since the glory days, when they dominated the market, and had customers lining up to place orders years in advance, they are now struggling for relevance. The value of the business as reflected in the share market has plummeted, along with their market share in a market that continues to explode in volume and value.
Arguably, Intel should still be in the position now held by Nvidia, current market cap 3.64 trillion, and rising like a kite in a hurricane. Intel, while still worth over a billion dollars, is small by comparison.
Any calculation of the opportunity cost of strategic choices made in the past by Intel would make shareholders kick their cats. Intel delivered astronomical profitability resulting from then CEO Andy Gove making the choice to move away from memory chips and pioneer the semiconductor market. The emergence of the PC in the 90’s made Intel one of the biggest and most profitable businesses ever seen. They then missed the move to chip sets designed to enhance gaming, which doubled as the enablers of the exploding AI market.
At least Intel shareholders can feel better, as the missed opportunity club is a very large one, with some distinguished members.
Note: the graph in the header is the Intel stock price. $1 in 2000 is now worth $1.83 adjusted for inflation. In other words, the current year low price of $19/share is worth just over $10 in 2000 dollars after inflation. This is in a market Intel used to dominate, and that has exploded over the last 5 years, with Nvidia grabbing the chocolates. That is the opportunity cost intel has suffered.
Aug 12, 2024 | Change, Strategy
2024 is very challenging for SME’s.
It is proving to be a time of an unusually high rate of SME mortality. This is driven by the problems that emerged with the Corona virus, followed by a period of historically low cost of capital, then a burst of inflation now being wrung out by aggressive rises in interest rates, the wars in Ukraine and Gaza, uncertainty of supply chains, and a host of other items.
It makes sense for every business owner to consider the value of their business. While having an exit plan is always a good idea, few are proactive in creating one.
While you may not be considering selling any time soon, (or going broke) it remains a valuable exercise to uncover the drivers of value, and double down on them.
Following is my list of value drivers, in a rough order, which will vary with circumstances and conditions in any specific market.
Cash flow.
Managing cash is the single most important thing every business can do to ensure survival, after looking after your customers. Cash is not subject to accounting rules, conventions, or differential tax treatment, as are the P&L and Balance sheet. You either have it or you do not.
Calculating free cash flow, the cash left over after capital expenditure over time, gives an extremely sensitive view of the health of a business.
Happy and committed customers.
You can make customers happy by giving discounts, but that is not a good measure of value. A committed customer will be prepared to pay at least the going rate for your products, and will not be moved by short term incentives from a competitor. Two of the best measures are Share of wallet and customer churn.
How much of a customer’s spend on a category you could supply, do you supply, and what is the ratio of customer loss and gain that is occurring. Committed customers will also be happy to refer you to others, simply the best form of marketing there is.
Customer & supply chain diversity.
‘Don’t have all your eggs in the one basket’ is a dictum that has proved true time and time again. Businesses that allow one customer to become more than about 25% of their revenue are dicing with trouble. In the event that customer goes broke, changes personnel at the top, gets taken over, or a myriad of other things that can happen in commercial life, you can find yourself out in the cold. This is the structural problem facing Australian suppliers to FMCG.
It is the same in your supply chains, but in reverse. Every business wants to be a dominating force in their supply chains, to be able to exercise some level of control. The pandemic has shown us how fragile our supply chains are, so resilience has become a key KPI for many who were previously reliant on single sourcing and JIT supply.
Differentiated in ways hard to duplicate that customers value.
Charlie Munger often spoke about building ‘Moats’ around his businesses. We all understand that a moat is a structure that repels invaders, in a commercial case, competitors. It is a lovely metaphor, and works irrespective of the scale and type of your business.
You build moats by being able to create customer value that competitors cannot or choose not to match, and if they try, their resources are consumed by the power of the Moat. This sort of protection is rarely a function of just one element, in the metaphor, the height of the moat wall and depth of the water. It is always a combination of many contributing strategic and tactical measures.
‘Tide’ detergent in the US retains 50% market share of the washing products market. Any quick look would indicate it to be a commodity market. Anyone with the right gear can make a detergent that does a good job, so how has P&G retained this share? It is a combination of time, disciplined brand building tactics, consistently very good advertising, continuous innovation, and an ability to ‘shape’ the market by being strategically smarter than everyone else. These have delivered first mover advantage continuously to P&G as the ways Tide delivers value to consumers have evolved.
Defined Process maps subjected to continuous improvement.
Imagine a potential buyer comes into your business with a serious intent to consider purchase. Anything you can do that reduces the level of uncertainty that they will feel about the value of your business to them is worth doing. If a buyer sees that business processes are mapped, consistently applied, and the subject of continuous improvement, it will be immensely reassuring. Such an environment will remove a significant source of uncertainty and risk.
Revenue Predictability
Revenue predictability is gold. Forecast accuracy drives not only sales up, but operational costs down, and revenue generation activity more directly connected to results, and therefore accountability.
Over the last 20 years, the nature of revenue has changed from one driven by sales, to one driven by subscription. Once you have a customer ‘signed up’ to some sort of process that delivers revenue automatically, they are both more likely to spend more, as they have a sunk cost to recover, and less likely to leave.
Amazon Prime is the most effective subscription model ever seen. Currently Amazon prime has 170 million subscribers in the US. For $14.99 monthly or annual subscription of $139, subscribers benefit from a range of ‘free’ services from across the Amazon ecosystem. Numbers vary, but solid research puts prime subscribers buying up to 4 times as much on Amazon as the average non subscribing Amazon buyer, up from around $500/year to over $4,000. Not bad when you can also manage the margins they are buying at, and have already banked $11 billion in advance.
My local coffee shop has a loyalty program, the 11th coffee free, so I tend to buy from them when it is convenient to do so. If the situation were reversed, and I had paid a membership up front in order to get a discount, the incentive to go there would be significantly stronger. Amazon Prime has harnessed this basic psychological driver to generate billions of dollars.
Having a clear set of robust leading indicators of revenues, margins and profit, offers certainty to any buyer of your business, as well as to you. They also offer the explicit platform for improvement.
Focus
To optimise your business, and thus enhance its value, it will pay to focus aggressively on the areas where you have some sort of competitive advantage that can be leveraged. This always come down to trimming product ranges, brands, geographies, technology bases, and market segments aggressively. While the analysis is tough, and the choices even tougher, you will inevitably find that the pareto rule applies, and aggressive application drives profitability. A mantra I use with clients is ‘Pareto the Pareto’, suggesting that this optimisation is a continuous process.
Clean books
Using the business as an ‘ATM’ for the owner is a danger sign for any buyer. When preparing your books for the inevitable Due Diligence examination by a potential purchasers accountant, the less items that are up for deeper examination the better. Ensure you have a ‘normalised‘ P&L available for scrutiny that identifies and explains or excludes all the items that may draw a question. Similarly, many SME’s claim to have some component of cash transaction in their business. Expect those claimed transactions and resultant cash to be completely discounted by a potential buyer as a source of value.
Steady growth history
Any potential purchaser is only looking at what you have done in the past, as an indicator of what might be possible in the future. They are only interested in understanding the future return on an investment they might make in your business. Therefore, a history of growth will be an indicator that all things being equal, there is evidence that the growth that will benefit them will continue. Growth that is relatively smooth is always better than growth experienced in fits and starts in the eyes of a buyer.
This applies equally to all financial and non-financial measures.
A strong management bench
Across functions, you need people willing and able to step up as you expand. A balanced and robust bench with solid succession planning through all levels is a hedge against the uncertainty that accompanies an acquisition, and benefits the value of the business.
An obvious culture.
Every business has some sort of culture, the ‘way we do things around here’. A consistent, explicit, and aligned culture that is aimed at delivering a well understood strategy is like cheese to a mouse: irresistible.
None of these are easy to address. If they were, the mortality rate of SME’s would be less than it is.
