All businesses have fixed and variable costs. The former remains largely constant irrespective of output, whereas the latter will vary, as the name suggests; increasing with increasing output. Businesses with high fixed costs in relation to variable costs are said to be “operationally geared”. This is because once all fixed costs are covered, there is an exponential increase in profits, for every pound of revenue earned, given the lower variable costs per unit of output. This characteristic of certain businesses can lead to impressive profit growth during good economic circumstances, often leading to sharp increases in share price for public quoted companies. However, this trait is a double edged sword. During periods of falling revenues, and with high fixed costs needing to be paid, regardless of top line performance, profits can quickly fall and turn negative. Whilst this could be expected in seasonal businesses, longer term trends could quickly put businesses under financial stress or in the case for public companies, see a marked reduction in share price as the market adjusts for the lower profitability.
This article seeks to examine, why it pays to invest in technology to support operationally geared businesses.
Cyclical Cycles and Need for Data
Market and industry awareness coupled with experience is invaluable in operationally geared businesses; especially those that are subject to cyclical or seasonal revenue flows. Whilst this will give a good insight into external factors, data and the quantification of performance or trends remains the nadir of prudent decision making. The time delay between calendar month end and senior management receiving reliable performance data is an uncomfortably common scenario. Compound this with an operationally geared business and the data, and decisions made as a result, might seriously lag the actual performance of the organisation. Risk in this scenario is exacerbated where profits are under pressure due to high operational gearing.
In so many organisations data is often maintained and collected in a plethora of line of business (LOB) solutions. Line of business solutions are the stalwart of a ‘best of breed’ technology strategy, where technology is highly targeted to a particular process area. Whilst there are certain industries needing highly niche, line of business solutions; a software ‘hairball’ often arises by incremental software purchases as a business grows. It almost always falls to the finance department to extract, transform, aggregate and load these various data streams into an ERP or accounting system to start to prepare the financial statements. Therefore, the flexibility of ‘front office solutions’ often is at the expense of process efficiency further down the organisational flow. As highlighted at the start of this section, the delay in producing performance metrics for an organisation that is operationally geared could have strategic ramifications. It would seem logical therefore, that rationalising the number of software systems a business utilises, or at the very least, increasing the efficiency of data flow to finance is a vital step in operationally geared businesses.
It would make sense to undertake scenario modelling, given the susceptibility for large changes in underlying profitability for operationally geared businesses. Often the initial driver for modelling software stems from the need to establish more interactive and system assisted organisational budgeting. Very common is also the need to more accurately model and forecast future cash flow. Given that cash is the lifeblood of an organisation – this is understandable; yet financial business modelling software (Enterprise Performance Management) solutions, rarely are value for money when forecasting this element alone. The ability for powerful technology to run “what if” forward looking models should indicate particular scenarios that leave a business vulnerable to a downturn in profits, should there be a downturn in revenue or reduction in gross margin. Furthermore the investment case for modelling software is compounded by significant time savings when establishing new models or changing existing ones. Changing variables order considering the effects of new items are ‘click-of-a-button’ changes, as opposed to copying spreadsheets or other more manual tasks. For operationally geared businesses, given the non-linear effect on profit with changing revenue, this modelling should allow an operationally geared business to plan for and mitigate as far as possible the impact of falling revenues.
Striving for Efficiency in Cost Base
Whilst certain business types will always tend to be operationally geared (e.g. manufacturing companies, airlines, software companies), technology in these companies can assist in achieving cost efficiency. This seeks to mitigate the effect of operational gearing on net profit by supporting rigorous cost control. For instance, a distribution or manufacturing company could invest in warehouse technology to increase the throughput of materials without needing to increase warehouse capacity. This makes most efficient use of the existing fixed cost base and avoids immediate future costs of otherwise needed expansion.
However, it is often the case when it comes to technology investment that companies and organisations are ‘penny wise but pound stupid’. if a business is spending money to maintain and firefight systems; i.e. ‘saving the pennies’, then it assumes an opportunity forgone to spend ‘pounds’ on a solution that can, not only avoid costs in the short run but further reduce costs in the future.
Technology & Operational Gearing as Advantage
This article has largely considered the application of technology to mitigate the downside impact of operational gearing by increasing cost base efficiency, either through reduction of actual cost or improvement in productivity. It is meaningful to highlight that whilst operational gearing increases the susceptibility for profits to reduce in downturns, technology can also be used to exacerbate its positive profit impact when revenues are growing. Technology investments that enable the business to grow top line revenue faster will have a higher impact in profitability for an operational geared business than in one which is not geared to the same level.
Technology investments could be made, supporting the business in introducing new product offerings, or alternatively offering more flexible and enticing pricing models for existing products. A global wide shift to subscription pricing models in many instances increases the frequency and complexity of invoicing customers. The move to bundle and un-bundle product offerings, increases upsell potential and opportunity for building large recurring revenue streams. For instance, whilst you could rely on a sales team themselves being aware of product cross-sell opportunities, technology investment could easily consider correlation metrics or proactively notify of applicable products the customer hasn’t purchased for instance. Both these scenarios would lead to an increase in the most common and successful upsells, thereby increasing top-line revenue from an existing customer base. As the article began, for an operationally geared business – this increased revenue per customer ‘certeris paribus’ would lead to a non-linear increase in profits.
The financial impacts of operational gearing are well documented. Indeed, given the impacts, many publicly traded operationally geared businesses have been both very successful and very poor investments as a result. For these types of businesses, irrespective of company size, this article has sought to highlight how technology can support a business in mitigating some risk of operational gearing, but how also it can exacerbate net profit further by driving increases in revenues. In the week before writing this article, the US Treasury yield curve inverted signalling potential recession. In a downturn, operationally geared businesses are most at risk, thus the technological investments insinuated in this article could prove important in the coming years.