After working with and analyzing numerous small businesses, I have noticed recurring patterns of behavior that often lead to failure. In almost every case, the root cause of a company’s difficulties lies in management, not in bad luck.
When a business that has operated successfully for years begins to struggle, it typically indicates two things: (a) the company still possesses valuable talent and expertise, and (b) ongoing management issues have gradually weakened the organization, making it more vulnerable to challenges.
This article will explore key problem areas in management that often trouble small businesses, with a focus on lessons drawn from operating small manufacturing companies. However, these lessons are also relevant to divisions of larger organizations.
Core Management Weaknesses in Small Businesses
Three significant areas of weakness commonly contribute to problems in small businesses. Each of these is rooted in management decisions:
1. Overemphasis on Sales Growth: Many managers believe that increasing sales will solve all problems, often overlooking that overhead costs are not fixed in the long run. This flawed approach is exacerbated by reliance on marginal income accounting, leading managers to introduce additional products without fully considering the impact on costs.
2. Inadequate Cost Analysis: Poor cost analysis prevents managers from identifying unprofitable products. Many companies continue to support products or product lines that should be discontinued.
3. Neglect of Cash Flow and Capital Productivity: Many businesses focus on the income statement while ignoring the balance sheet. A lack of attention to cash flow and the efficient use of capital often leads to financial trouble. Instead of optimizing existing resources, managers frequently look for new funding.
1. Growth for Growth’s Sake
The most common problem is the belief that growth in sales is the ultimate measure of success. However, growth alone rarely solves problems. Shrinking the number of products or narrowing the focus often results in better profitability and a higher return on investment.
Marginal Income Accounting
Managers often rely on marginal income accounting, which assumes that additional sales can temporarily boost profits, even at prices that don’t fully cover fixed overhead costs. While this approach can be helpful during brief periods of overcapacity, it is dangerous when used as a long-term strategy.
For example, one manager, following advice to price products just above direct material and labor costs, found his company in serious trouble. While such tactics may seem to improve short-term profits, they usually increase overhead costs and complexity, leading to long-term losses.
Break-Even Accounting
Another flawed practice is break-even accounting, which assumes that fixed and variable costs are distinct and predictable. In reality, most overhead costs are variable over time. By treating expenses like rent or executive salaries as fixed, managers often underestimate their flexibility and fail to control costs effectively.
The belief that increasing sales is the only way to cover overhead leads many companies into trouble. For instance, one executive viewed high fixed costs as unavoidable and focused on driving sales to meet those costs. This approach often results in inefficiencies and financial strain.
2. Inadequate Cost Analysis
Cost accounting is a useful tool but has limitations. It excels at tracking direct costs, such as materials and labor, but often fails to allocate indirect costs accurately. New product lines, which require significant startup resources, are rarely charged the full amount they consume, while established lines bear a disproportionate share of costs.
The Benefits of Simplification
Simplifying operations by reducing complexity can have significant benefits. Recognizing that all overhead costs are variable—though some may take time to adjust—allows managers to identify and eliminate unnecessary expenses.
For example, one company discontinued an unprofitable product line that required excessive management attention. The decision to sell the line not only improved the company’s balance sheet but also reduced complexity and boosted overall profitability. Simplification often leads to greater efficiency and better results.
3. Focusing on the Right Objectives
A manager’s primary role is to maximize business opportunities, not to address every minor issue. Simplifying operations and focusing on a limited number of goals often yield the best results.
Prioritize Product Lines
Start by analyzing each product line. Identify which ones contribute to growth and which are holding the company back. Often, low-margin product lines consume more resources than they contribute. Eliminating these products can free up resources for more profitable ventures.
For instance, one company struggled with an old product line that had been a cornerstone of its business. Despite declining sales and consistent losses, management hesitated to let it go due to its perceived importance in covering overhead. After selling the line, the company reduced overhead, freed up capital, and became profitable within a year.
Conclusion
Managing a small business effectively requires clear priorities, rigorous cost analysis, and a willingness to simplify operations. Growth should not be pursued at the expense of efficiency and profitability. By focusing on core strengths and eliminating unnecessary complexity, managers can build more resilient and successful businesses.
