Ready for the downturn

Industrial Engineer, Feb 2008 by Engle, Paul

CLASSIC PREDICTORS OF AN economic downturn are visible on the horizon. Is your company ready?

Economic expansions cannot last forever: Sooner or later, they come to an end. The current period of expansion has lasted more than five years in the United States. Economic pressures are building in the form of a weak dollar, tightening credit, high energy prices, and weakening consumer demand.

Many of my clients are ignoring these signs and are budgeting for another year of expansion. Plans are in place to invest in plants and equipment, hire additional staff, and launch expensive marketing campaigns. They view their particular market as somehow insulated from the problems that the economy faces and are eager to continue to fund the same levels of growth of the previous fewyears. Many feel that recession fears are overstated.

My experience suggests that companies inject a note of caution into their plans for the new year. While long-term initiatives such as capital equipment and plant expansions should probably continue, other areas should be closely monitored, and some plans pushed out or tabled until the economic picture becomes clearer.

The most critical areas involve cash. Two large cash consumers are inventory and receivables. As the economy cools, my firm recommends that our clients reduce raw material purchases to maintain inventories at normal levels and to monitor receivables in a more aggressive manner. Many companies are slow to make these adjustments, creating large inventory balances, and ballooning receivable balances, that may take months or even years to correct.

These two areas may consume cash at a staggering rate, quickly depleting reserves that have taken years to build. Banking partners have been greatly impacted by the residential mortgage crisis, and lenders are becoming increasingly sensitive to risk. This may translate into higher rates and fees, or even an unwillingness to provide additional working capital.

It is difficult to support inventory reductions and proper management without a lean supply chain and efficient inventory practices. Lean supply chains pull only enough materials to replenish inventories. They can easily be adjusted in times of slowing demand by reducing kanban quantities and working with suppliers to reduce lead-times.

Clients continue to use sophisticated demand planning tools in an attempt to anticipate demand swings and build large inventories. This strategy may fail to react quickly enough in a demand downturn, resulting in an increase in unsold stocks. Inventory balances normally measured in days and weeks of usage may now represent months of demand. Large amounts of unsold goods require the cash to support them but also must be stored and counted and may become obsolete, stolen, or damaged.

As the economy weakens, customers may also become short of cash, and creditors represent a low-cost alternative to bank debt. Failure to identify problems as they develop may result in large cash investments to support slow payers or even increases in bad debt reserves.

Leading companies are proactive in preparing for difficult economic times. While they are aggressive in growing their businesses, they use world-class techniques to minimize, monitor, and manage inventory balances and receivables in order to mitigate the risk caused by softening in demand and tightening credit.

Companies with a contingency plan may not avoid its effects, but they can minimize the impact to their income statements and balance sheets while the economy recovers.

Paul Engle is a senior manager with Grant Thomton's Management Advisory Services. Engle, who holds M.B.A. in finance, has more than 25 years of experience in management, operations, product development, sales and marketing, strategic planning, and business process improvement consulting.