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Why Current Profitability Model is Unsustainable By Dr. Bill DeMarco
Profitability is the gaining of advantageous returns on investments. When I began my career decades ago, there was some discussion about the role of service to customers, service to employees, and service to the community as a major if not primary purpose for a business’s existence. That was still the era of mutual insurance companies, multi‐generational company employers, and company dominated towns.
“Defined benefit” (DB) programs were real and highly valued. The past few decades have seen a shift to fundamentally profit‐driven corporate models. Even mutual insurance companies, originally founded to perform some noble purpose for widows, orphans, and the general public, have almost all migrated to for‐profit models. “Defined benefit” programs have given way to “defined‐contribution”(DC) programs, which derive the funds for “benefits” mostly from stock investments. In Ontario over the past twenty years, pensioners rarely receive pension checks from funded company plans, because companies mostly failed to fund their pensions by taking “contribution holidays” If in surplus; or in the case of solvency deficiency, they were allowed to amortize unfunded liability for up to fifteen years. (Ontario Pension Benefits Act, 1990), Ontario pension law was not significantly different from other North American jurisdictions. Companies that took this course of action hoped to achieve higher market evaluations, stock splits, and other market‐related activities which would generate “money” over time, putting a happy face on quarterly and year‐end numbers. To illustrate this, I once had a major Fortune 500 company client which had a fantastic year‐end in Europe, driven in no small part by the strength of the American dollar vis‐à‐vis the German Deutschmark. Their European executives received large bonuses. In all these cases, irrespective of whether it was pension‐related or not, we have examples of a “fools gold” model of what good performance looks like. Like a drug addiction, these companies over time failed to see what was happening until it was too late. The Fortune 500 company I mentioned, like so many others, was eventually sold off in parts. They all failed to recognize what really counted was truly growing the business through innovative new products, superior customer service, increased sales, constant happy returning customers and more effective operations; for companies with underfunded pension liabilities, this is particularly more important than the risky roll of the dice they too frequently engage in.
Governments in both the U.S. and Canada, responsible for overseeing the funding of contractually agreed to pension plans, allowed this, frequently charging an administrative fee for deferring funding company pensions, placing those fees into government operating funds. All of this has led to a domino effect, not unlike families today relying on borrowed money (credit cards, lines of credit, home equity loans, etc.)…it looks good in the beginning until it comes time to pay the bills, or the income line slows down.
In the early to mid 1990’s, it seemed to work well for everyone. These diverted pension funds initially bolstered quarterly company and government numbers. Many pension funds even ran surpluses, while quarterly company profits looked rosy. As time went by, these under funded pension liabilities reached minor (1999) and major (2008) tipping points as stock values deteriorated. Coupling these events with the ever‐increasing number of retirees, companies frequently faced a perfect storm. The beat went on so relentlessly that by the end of 2011, 93 percent of federally regulated DB plans were under‐funded according to the Office of the Superintendent of Financial Institutions of Canada. The situation has gotten even more dire since then. For example, an August 2012 study by the credit rating agency Dominion Bond Rating Service Limited (DBRS) looked at 451 major corporate DB plans in the United States and Canada, including 65 north of the border. It found funding deficits of US$389 billion. DBRS noted more than two‐thirds of the plans were “underfunded by a significant margin” and heading into a “danger zone,” the point at which reversing the deficit becomes very difficult.
I am not attempting to be critical of stock holders or pensioners here, for they are on the receiving end of a profitability model which common sense would dictate is not sustainable for the long haul. Unfortunately, there end up being multiple victims in this scenario … including stock holders/pensioners who rely on recurring profits for sustenance and lifestyle choice.
There are fundamentally two ways of achieving profitability: (1) grow the business through the judicious design and distribution of market‐desired goods and services; (2) cut costs. The latter has become the dominant, and uninspired business/government means of obtaining more desirable numbers, because for all its heartlessness, it is easy to achieve and does not require much real business imagination. Of course companies need to be judicious with how they manage their businesses. However, there is an increasing obsession today with beating the analysts’ predictions, getting “bigger” at all costs, being the biggest in the industry at all costs, beating last year’s numbers no matter what, etc. etc. Company and government decision‐makers have become too often addicted to the opiate of what I call “cut‐cut, chop‐chop leadership”, as if there is an endless supply of physical and human resources to be cut, or suppliers willing to provide goods and services for almost nothing. In this scenario, the temptation to cut salaries/benefits is great since human resource expenses account for over 50% of overall company expenses, and the saving can go to the bottom line almost immediately.
Key business and government decision makers, including boards of directors, need to be weaned off of this addiction to “chop‐chop cut‐ cut leadership”, partly because of their fiduciary responsibility to sustain the enterprise. This management addiction is absolutely not sustainable for the long haul. In 1957, the average life expectancy of a company in the S&P 500 index was 75 years. Today, it’s just 15 years. There absolutely is a better way. It requires inspiration, courage, and real leadership where the enterprise is given a real purpose, recognition in high places that making money is a result not a purpose, and stakeholders at all levels give their willing effort to support that purpose. This is not a call to go back to a bygone era of any form of utopianism (welfare/ social / Nordic/ Rhine capitalism). Rather, it is a call for a common sense which recognizes that current profitability models are unsustainable, and that senior executives need to both think and behave for the long haul, rather than leaving this untenable situation for their successors to handle!
Let me offer an example. About twenty years ago, I was a senior executive at a major consulting firm. A client of our firm for many years was a global aerospace company, known for its decades of engineering creativity and performance. In recent years, they were having difficulty growing the business, mostly due to a risk-‐averse culture and leadership. The firm’s CEO and the board really needed positive year‐end numbers to beat the buzz on the street about the company’s financial underperformance. Since I was responsible for our Organizational Effectiveness Practice, our consultant responsible for the account asked me to come in to help the special ad hoc committee put together by the CEO to come up with some way to quickly improve the bottom line numbers. The reality was that the CEO had a white knight willing to “invest” several billion dollars for new research, subject to agreeable year‐end numbers. The committee chair was an executive vice‐president. He and his staff had come up with one recommendation, which they wanted me to put our firm’s reputation behind when he presented it to the CEO. The suggestion was to implement an early out program for all employees over 52 years of age. The amount saved in salary and benefits would marginally surpass the targeted amount sought. I asked one question: “Does an aerospace engineer with thirty‐plus years experience have more to offer the enterprise than an engineer with ten plus years experience? Why get rid of all that knowledge and capability? “ His response was they had that covered. They would hire back senior engineers as consultants as needed. If I was a stockholder, I would have been appalled…simultaneously paying out retirement benefits, generous exit packages and high consulting fees, while losing the resident capability that made the company great. I and my firm refused to support the idea. To no one’s surprise, the company went ahead with the plan any way. The company beat the street’s year‐end expectations… executives got hefty bonuses. Most importantly, the company was bought up by a competitor in a fire sale less than two years later. Truly a long‐term victim of risk‐aversion and “chop‐chop, cut‐cut” leadership!
So what is a better way? Is it possible to be profitable now and for the long haul? What does a sustainable profitability culture look like? It starts off with leadership which gives purpose to organizational effort while inspiring willing effort to support that purpose! Part Two will cover the specifics.
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Family vs. Business by Family Wealth Coach
As a business owner, you take on a unique challenge. Every day you are faced with both business and family decisions. And family business owners deal with this even more.
Sometimes people feel that those two aspects of their lives are really at odds with each other. They absolutely can be—but they don’t have to be if you manage both of them carefully.
Think about your family and business in terms of a pendulum, or a teeter-totter. Your family is on one side, and your business on the other. Every decision you make will have both business and family implications. For example, promoting one of your children as CEO, or even deciding when your children will engage with the business as either employees or shareholders, will have an effect at home and at work.
Sometimes you will have to prioritize business over family, or family over business. Again, think of the teeter-totter, when you make a decision for one side, the other side will also be impacted.
The key take away here is that Estate plans have to consider both – who gets voting control, who will manage the business, how will you look after your family? Balancing a teeter-totter (or a family and a business) is not easy when both sides are so intricately linked to each other.
The name “teeter-totter” may suggest otherwise, but finding the equilibrium is always possible with some careful planning and accurate adjustments. The same is true for your family and your business.