A manager needs to monitor: The business unit’s vulnerability to recession Their contingency plan for dealing with recession *Day-to-day operations
Managing through the Business Cycle
| Steps | Description |
|---|---|
| Assess vulnerability to the recession | “How vulnerable is our company to recession or a slowdown in sales?” Assess the vulnerability in terms of magnitude and timing of slowdowns in sales using national data on the company’s industry. |
| Sketch out a contingency plan for dealing with a recession | It’s an one or two page plan, which can lead a manager to build flexibility into the business. |
| Build flexibility to cut expenses | A company needs the flexibility to cut costs in difficult times. A manager can build flexibility in the business by considering the following areas.
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| Develop an early warning system. | In 1940, the Battle of Britain began as 2,400 Luftwaffe aircraft attacked England. The Royal Air Force had only 900 planes., yet they successfully defended their country from the Germans. They key to their success, was radar. The early warning system is “radar for business.” |
The vulnerability assessment sets the stage for contingency planning Industry data is often the best way to gauge your business’s vulnerability The CFO will be a key player in getting the company through a slowdown Note that use of the company’s historical experience could be quantitative, as when an analyst examines actual sales figures from past eras, or it could be qualitative, as when a seasoned executive remarks.
Plan to develop a contingency plan for dealing with an economic downturn The senior management team must sketch out a plan for recession long before any forecaster forecasts a recession. *Preparation of the contingency plan identifies issues where flexibility will be needed and areas in which bold moves will be necessary, as well as opportunities for growth that may occur.
Many ordinary business decisions limit or increase flexibility in the future. All such decisions need to be made with a conscious understanding of how much flexibility is being gained or lost. Preserving the company’s options for dealing with difficult time is a major responsibility of senior management in good times. Relationships with vendors and customers need to be managed in good times with an eye to survival in the bad times. Capital spending plans should be developed with an eye to flexibility. Recessions are hard to forecast, so anything that lengthens the time period of a capital project also increases the risk that a recession will develop while the project is under construction. *throughout the good times, management needs to keep in mind the potential for a serious decline in sales. Humility is important to survive in difficult times.
A company that learns in its contingency planning that it has limited options for cutting expenses may spend a year adding flexibility wherever it can.
Explan each of the following terms in your own words. The author explains the terms in the textbook. If necessary, you may also Google the term on the Web. Good resources include:
Explain the terms in your own words briefly.
The NAICS is the standard used by Federal statistical agencies in classifying business establishments for the purpose of collecting, analyzing, and publishing statistical data released to the US business economy.
In economics, marginal cost is the change in total production cost that comes from making or producing one additional unit. Calculating the marginal cost allows companies to see how volume output influences cost and hence, ultimately, profits.
Economies of scale refers to the phenomenon where the average costs per unit of output decrease with the increase in the scale or magnitude of the output being produced by a firm. A business’s size is related to whether it can achieve an economy of scale - larger companies will have more cost savings and higher production levels.
Capital goods are the assets used by businesses in the course of producing their products and services, and can include buildings, machinery, tools and equipment.
Equity represents the value that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company’s debts were paid off. Equity can also be the degree of residual ownership in a firm or asset after subtracting all debts associated with that asset.
A bond is a debt security. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time. When you buy a bond, you are lending to the issuer, which can be a government, municipality, or corporation.
A bank loan is when a bank offers to lend money to consumers for a certain time period. As a condition of the bank loan, the borrower will need to pay a certain amount of interest per month, or per year. An example is a mortgage loan.
A line of credit is a preset borrowing limit that can be tapped into at any time. The borrower can take money out as needed until the limit is reached. As money is repaid, it can be borrowed again in the case of an open line of credit.
Commercial paper is an unsecured form of promissory note that pays a fixed rate of interest. It is typically issued by large banks or corporations to cover short-term receivables and meet short-term financial obligations, such as funding for a new project.
Describe the characteristics of the following events briefly.
The author uses this as an anecdotal example to explain the danger of inflexible labor contract. Elaborate. General Motors has committed the greatest foolishness imaginable in limiting its flexibility through its “Jobs Bank” program. Detroit automakers spend at least $1.4 billion a year paying workers not to work. This idea had some logic back in the old days. This program depended critically on forecast of future sales. when the forecasts proved to be overly optimistic, the company lacked the flexibility to cut expenses. The inflexible labor contract led GM to another faulty decision: continue producing cars even when demand is weak. Because it could not cut its labor costs, the marginal costs of making a new car was simply material expenses. GM failed to recognize the value of flexibility in a world with imperfect forecasts, and they suffered for this error.
The author uses this as an anecdotal example to advocate for smaller modular investment in stages. Elaborate. The electric utility industry was regularly whipsawed in the 1980s and 1990s. People have a hard time cutting back on electricity usage in the short run but a much easier time adjusting in the long run. The utility’s problem was their preference for large billion-dollar power plants. Those large plants typically had operating costs much lower than a small plant - economies of scale, in economic jargon. However, technical efficiency doesn’t count fro much if the customers don’t need half of the installed capacity. After sales growth slowed, the industry was caught with excess capital management. Over time, the electric industry has switched to smaller, more modular generators. Their price tags are smaller, and their construction cycles are much shorter. That means that installation of the new facility begins much closer to the time of actual need. The small plants have a flexibility that outweighs the cost disadvantage.
The author uses this as an anecdotal example to advocate for borrowing with staggering maturities. Elaborate. The Penn Central was financing a large portion of its operations with commercial paper, which is a short-term loan. The recession of 1970 lowered freight traffic and thus Penn Central’s revenue and internal cash flow as well. Penn Central’s creditors got nervous about the railroad’s ability to repay it’s debt, and they refused to roll over $82 million of commercial paper. Had the Penn Central financed its operations with bonds, they would have survived until the economy rebounded in late 1971. The railroad went bankrupt. When financing with bonds, make sure that the maturities are staggered. Having two or three bonds all come due in the same year is a formula for disaster if that year happens to be in a recession. Having at least two years between maturities is necessary for all but the largest corporations.