Business musings

Once upon a time, in May 2010, John and his team at EngCo Ltd were competing to win an order from a firm in the US. John knew they could deliver a high quality job and it was a company they’d wanted to work with for some time. They’d also done their due diligence and knew the company had plenty of cash reserves, so payment shouldn’t be an issue.

Together, the team at EngCo worked out a price that included a 10% profit margin on the work and sent the US firm a quote for £244,000. However, the company shortly came back to them and asked for the quote in US dollars (USD) instead of pounds (GBP). John readily agreed and his sales manager duly converted their fee. Using a currency converter, she moved everything into dollars with a conversion rate of 1.4334 on 20 May 2010, rounded the figure up to $350,000, and sent the quote off again. The US company quickly accepted and John and his team were thrilled to have been selected!

EngCo got started on the work straight away, spent a couple of months completing the order and invoiced the client in early August. The client was delighted and paid almost immediately.

Great news…or not so much!

The trouble was that, having converted their original quote to US dollars, EngCo only received £219,485 instead of the £244,000 they’d accounted for! In the process, they effectively lost £24,515 and just over 50% of their profit margin.

So what went wrong?

When the US client paid EngCo Ltd, the exchange rate for USD to GBP was 0.6271. This meant that although the US company still paid $350,000 at their end, EngCo received much less than anticipated as they had converted their quote when the exchange rate was more favourable.

What could John have done differently?

There are a number of things that John could, and should, have done to protect EngCo from the risk of exchange rate fluctuations.

Quote in EngCo’s own currency

To be fair to John and his team, this is what they did initially and all would have been fine had the US firm not asked for a quote in US dollars. The team could however have been smarter when dealing with the request for a new quote.

For example, John could have quoted in dollars but negotiated with the client over who had exposure to exchange rate fluctuations and within what limits, thereby triggering a re-calculation mechanism should exchange rates become unfavourable.

He may also have been able to negotiate phased payment for the project (including an upfront deposit), again reducing EngCo’s currency exposure and significantly smoothing their cashflow.

Foreign currency account (or local bank account)

Another simple solution would have been to set up a US dollar account with EngCo’s bank and ask the US company to pay into this (John would simply have needed to provide the client with the IBAN and BIC numbers for the currency account). While this wouldn’t have protected EngCo from currency fluctuations at the point of conversion, John would have been in control of when the monies were converted to GBP (unless, of course, he needed the cash to cover overheads, in which case this option would have offered less benefit).

Setting up a foreign currency account would have also meant that if John had further expenses in the US (such as setting up an international office), he would have been able to pay in US dollars directly from this account, thereby entirely removing any exchange rate risk from these transactions.

Alternatively, if John was committed to the US market, he could even have set up a local US bank account through his existing UK bank. This option would have been particularly attractive if EngCo ever wished to give the impression of being a local US company.

Forward foreign exchange contracts

If John had been completely certain of when his team would invoice and when EngCo would be paid, he could have set up a forward foreign exchange contract. This would have meant that John was committing to converting $350,000 to GBP at a fixed point in time and at a pre-agreed exchange rate—a great solution for removing exchange rate uncertainty in a predictable transaction.

That said, a forward contract would also have had the potential to expose John to significant risk if he had not been paid on time. A forward foreign exchange contract requires that, whether payment has been received from the client or not, the exchange must be actioned regardless. Had John not been paid, he therefore would have had to find $350,000 from somewhere else in EngCo!

Similarly, if the August exchange rate had instead gone in EngCo’s favour, John would still have had to convert at the agreed forward contract rate, thereby missing out on any additional profit.

Currency options

Currency options are in some ways similar to forward foreign exchange contracts in that they enable you to buy or sell currency at a specified exchange rate at a given time. As the name suggests however, the key difference between currency options and forward contracts is that options are optional!

If John had pursued this path, he could have bought an option to sell EngCo’s US dollars at a pre-determined exchange rate but later decided whether or not to use the option. John could even have purchased an option before he knew he had won the contract, giving him the security that, whatever happened, EngCo’s margins would have been protected. If EngCo hadn’t won the contract, if the client had failed to pay when expected, or if the August exchange rate had gone in EngCo’s favour, John could then have simply chosen not to use the option, only taking the hit on the option premium.

Don’t leave your foreign transactions to chance

As John’s story illustrates, currency can have a significant impact on your profit margins and you can incur huge losses if you’re not careful! We tell the story here with two fairly stable currencies but the risks and effects are magnified further when dealing with countries in which currencies are more unpredictable.

For those of you who are looking at internationalising or are dealing with international clients, take heed! The uncertain financial environment that we find ourselves in at present only increases the likelihood of uncertain and extreme currency fluctuations, so don’t leave your transactions to chance.

Similarly, in our story, John was certain of the buyer’s ability and willingness to pay and he was able to cover his working capital requirements through EngCo’s reserves: if a relationship with a client is less certain for any reason or you are unable to fund the cashflow requirements of the project yourself, you should also look at reducing risk through various export finance and insurance options.

I went to the Barclays ‘Let’s Talk More Profit’ seminar in the latter half of last year and have been meaning to post this blog for a while. Robert Craven, author and consultant, spent half a day talking to around 200-300 companies about how to increase their profits. I found it really useful and practical, so thought I’d share the key message.

There are only 5 ways you can increase your profits…
and not all of them are created equal!

Here are the only 5 ways you can increase your profits:

1. Raise your prices
2. Lower your direct costs
3. Fix the underperformers
4. Increase volume
5. Lower your overheads

And the winner is…

We looked at each of the five methods of increasing profit, and looked at how effective they each were. In reality, increasing your prices is by far the most effective way of increasing your profits.

Let me give you an example:

If you sell a widget at £100, with a cost of sale of £70, this creates £30 gross profit
However, if you reduce the price by just 10%, and sell it at £90, with the same cost of sale of £70, this only creates £20 gross profit.

Therefore, you would have to sell 50% MORE widgets just to make the same amount of profit you had been previously.

So, raising prices has the opposite effect. Sell at £110, less cost of sale £70 = £40 gross profit. A 33% increase in gross profit.

The counter argument is that, based on the supply and demand curve, you would expect to sell fewer widgets if you are charging a higher price, therefore making less money. The bit about selling fewer is true; the bit about less money depends on the demand curve. There is more profitable flex in this than you might imagine.

Say you sold 100 widgets at £100 making a total gross profit of £3000 (£30 profit on each widget x 100), then increased your prices to £110. You would now only need to sell 75 widgets to make the same profit (£40 profit on each widget x 75 =£3000), resulting in less work (and therefore overheads) for the same amount of money.

In addition, it is likely that your ‘worst’ customers are also the most price sensitive and will take up the majority of your time.

So, let me put it this way…

If you would like to work less, earn the same, and get rid of your least favourite customers… consider putting your prices up!

You can then spend the time you have saved looking for new, higher paying customers. When you have found these new customers and returned to selling 100 widgets, you will now be making £4000 profit instead (an extra £1000).

The only proviso is to be aware of demand sensitivity: if your business’ particular demand curve is very price sensitive (for example, if you were raise to prices by 10%, you would lose over 25% of your customers) you will then end up making less money, not more. That said, this sensitivity may be counteracted by upgrading your branding, customer service, or product/service differentiators to justify the price increase and thereby retain more existing customers. Raising your prices might mean raising your game, but then when has that ever been a bad thing?!

And finally, what about the other 4…?

The other 4 listed above are also very valid. Robert Craven suggests you work down in order, from 1 to 5. Implement each element and then move onto the next. By working in order, you ensure that you start with those that will have the most impact on your business’ profitability.

So, why not consider giving it a go!

As businesses are starting to report a slowdown in sales and a weakening in their financial position, there has been a lot in the news about a serious recession pending for the UK, especially after the report from the British Chambers of Commerce.

So, how should you respond? Do you know how you can make your business stronger and more competitive and therefore better able to deal with a recession? Markets shrink in a recession so where there were lots of people wanting and willing/able to pay for your product or service before, there are now less people able to purchase what you have to offer. That means you are going to have to change your strategy to win the remaining customers and fight off your competitors.

Here are 5 steps to prepare your business for a recession…

1. Plan for the future
   Don’t just meander along hoping for the best – plan! Your business will work best if you know where you are trying to go and what you are trying to achieve in the next 3-5 years. It doesn’t have to be a long, detailed or ‘impressive’ strategy, but it does require thought!
2. Draw up an action plan on how to get there
   You will need decide on short, medium and long term actions out of the strategy you drew up. These are specific actionable things that you can start working on, starting immediately. There will be both big things that you can do to improve (break these down into manageable parts) and also lots of little things. Don’t forget to prioritise.
3. Forecast your money
   Prepare a 3-year financial forecast or get someone to do it for you (like your accountant). Add in your costs and expected benefits from the action plan above. Even with a positive economy businesses often over-estimate sales, so be careful. Try cutting your revenue in half and see what it looks like; how would respond if that actually happened? Try cutting it in half again. Keep updating it monthly so you can see where you are against your plan. This will give you early warning of when you might run into problems. If things get really tight, then move from a monthly cashflow forecast to a weekly one, and watch your money like a hawk. When you see a problem do something about it in advance – don’t just wait for it to hit you!
   
4. Spend time working on your business not in it
   In order to implement your plan you will need to starting working on your business. It’s the difference between say, restoring and renovating a house and just cleaning it. It can be hard work and uncomfortable knocking walls out, getting a plasterer in etc. but you end up with a much better house at the end of it. Don’t fall into the trap of just doing continual maintenance work when  actually there is significant change that needs to happen. Don’t get me wrong, maintenance is important but it won’t significantly push your business forward. Your business needs to be the best it can be in every area. If you don’t have time to do this, then you either need to make time or find someone to work with you to implement the action plan.
5. Don’t stop marketing, just do it better
   As things start looking tight many companies start to reduce their marketing budgets. Proceed with caution on this one. You should do a separate 12-month marketing plan that links into both your strategy and your general business action plan. You might not know how effective your current marketing actually is; measuring its effectiveness can be hard but certainly not impossible. Marketing shouldn’t just be seen as a cost – it should bring in more business in monetary terms over the year than you spend on it. It is worth noting there are no silver bullets when it comes to marketing; it is about a consistent, focused approach in line with your branding and strategy (hence the plan!). By all means, put your marketing effort under the microscope and work to make it more effective, but don’t just cut it to cut costs; there is a real danger that you’ll end up cutting yourself off from your life blood – your customers!

Though it would seem that there are difficult times ahead, don’t panic and don’t give up. Times like these can actually be a real opportunity. Whilst you might worry about what is just around the corner, the fact that you are looking at what you can do about it now puts you in a much stronger position than most. This could be your opportunity to build a stronger, more resilient organisation and to outshine and outperform your competitors.