Last week, we introduced a sweeping definition of business losses by trying to capture all types of business impairments, including the potentialities of their occurrence, irrespective of whether we can measure and ascribe financial values to them or not. We posited that this is important because the entrepreneur needs to be aware of and alert to those events that can trigger damaging losses at the present or in the future but which they may not necessarily be able to specifically predict or ascribe exact financial values to.
On the basis of the foregoing, we will broadly classify losses into two groups viz, ‘technical’ and ‘potential’. By technical losses we mean those losses than be described in terms of actual financial measures that will be seen in the income statement and will affect the statement of financial affairs of the business. Most of the types of losses we mentioned last week, such as operating and capital losses, normal and abnormal losses, etc., tend to be what we can call technical losses. Non-technical or ‘potential’ losses are those losses that may occur now or in the future as a result of the occurrence of an event but which we may not be able to predict the exact quantum of their impact. Such ‘losses’ might, at best, simply reduce the level of profit that we ordinarily could make or at worst actually lead to net losses. In other words, non-technical losses are the likely consequence of missed opportunities or weakened capacity to achieve certain levels of profits that we, otherwise, could make. Furthermore, such losses cannot necessarily be measured or show up in financial statement as in the example of a high-flying salesperson leaving a business that we mentioned last week.
Classifying losses this way is important so that we can understand them and be able to take action to avoid, manage and reverse them. We will begin by taking up technical losses, what causes them and how we can handle them under various scenarios before we take up capital losses along the same format next week.
Losses caused by outright negative gross margin: Sometimes, the financial situation is such that the gross margin made, which is the net of sales revenue above the cost of goods sold, is at the onset negative. In other words, the cost of goods sold (‘COGS’) is higher than the sales revenue generated. This might be possible because you are either under-pricing (selling at some price, probably to undercut competition, even as you may be able to sell at higher prices) or the market is simply unable and/or unwilling to take your product at an otherwise profitable price you want to sell at.
In the first case where you are selling below what the market can afford, you will need to reconsider why you are selling below your cost. If it is because you want to push for the sale of other products, as in a loss-leader proposition, then you will need to be clear about the quantum of loss you are taking on one hand and the benefit you may be deriving on the other. If the benefit justifies the ‘loss’, you can continue on with your strategy. If the reverse is true, however, then you will need to revisit your strategy.
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In the situation whereby the market is unable and/or unwilling to take your goods at a price that is profitable to you, you will have narrower and tougher options. First, you will need to return to your ‘drawing board’ to try to understand the structure and composition of your COGS. Can you entirely cut out some components of your material, labour and direct overheads costs? If you can’t entirely cut out costs, are there are savings you can make on them? Besides cutting costs though, sometimes the problem may be because you are wrongly positioning your product in the market, thereby denying yourself of the benefits of pricing your products better. If, for instance, you set up your high-end restaurant in a lower-than-middle-class neighbourhood, you will be unlikely to succeed in pricing your offerings as well as you could compared to if your restaurant was located in the ‘right’ neighbourhood. It is the same with many other businesses, as your product positioning will determine your pricing window.
Losses caused by positive gross margin that is unable to cover selling, general and admin expenses: This is probably the most common cause of losses in a business. We make a positive gross margin, but the margin is not sufficient to cover our selling, general and admin (‘SGA’) expenses. We see this loss clearly in our income statement and it erodes our asset base in the statement of financial affairs to the extent of the loss.
This type of loss is generally caused by at least one of three possibilities: A positive but low gross margin made on individual products sold; A low volume of the units of products sold; or a collectively high level of SGA expenses that simply erode whatever positive gross margin there is.
With the first possibility, you will need to check the options of increasing your price to boost the already positive margin. There are limits to this though, and you have to exercise caution by, perhaps, making sure that you do not get out of competitive range. With the second possibility you will need to check what the market size is and what size of the market your competitors hold. If the overall market size is insufficient to make your business profitable, you might have to begin to consider leaving the space unless you can expand the market. If, on the other hand, your competitors have substantial size of the market and they are profitable, you may need to develop a strategy of snatching more of the share of the market. If you cannot increase your market share, you may not survive in that business unless you can substantially lower your breakeven volume. In the last case of high SGA levels, you will need to identify each account in the SGA to establish where you are probably spending more than you should or those spendings that offer no value to what you are doing. In either case, you should consciously identify and take measures to cut down excess costs and remove those that add no value. In doing so, a timeframe should be taken to ensure that the reversal is pursued with vigour to avoid possible bankruptcy and a return to profitability.
In addition to the broad generalisations above, specific operating/current assets can also attract losses in several ways for us. For instance, when we make credit sales, chances are that some percentage of the sales might not be paid back over time. We need to charge such losses appropriately; learn how we can minimise their recurrence and just generally ‘move on’. Losses can also be suffered in raw materials, work-in-progress and even finished products in the course of handling and processing. In such situations we should try to introduce the highest standards of efficient handling and processing to minimise the ‘normal’ losses whilst also giving the losses suffered the right accounting treatment.
Next week, we will conclude on operating losses and take up capital losses and non-technical losses and what can be done about them.