Atomic Energy

Ticket sales agencies, ever protective of their exclusive right to sell (and profit by the sales of) tickets to sporting, cultural and other events, have waged war against “scalpers”, i.e. ticket resellers, for years, if not decades. Many states have on the books, either now or at some time in the past, laws against scalping, especially if the resale price is above the ticket’s face value. On June 8, 2009, the Wall Street Journal published an article how Ticketmaster is using paperless technology, familiar to many from airline e-tickets to thwart scalpers. The article is available here. It is interesting how a technology designed to simplify the life of purchasers and increase their flexibility is being adopted primarily to constrain those purchasers.

It is the view of this article that Ticketmaster, in waging war against scalpers, is actually hurting itself. Scalping could not exist without demand, in a way similar to how cocaine or marijuana supply could not be lucrative if there were no serious demand for it. As an important aside, this author does not support the usage of drugs, or criticize the efforts of federal and state agencies to remove the scourge of illegal drugs from society. It simply analyzes the impact of such efforts on the market, as a way of understanding the impact of anti-scalping activities. Furthering the analogy, the more Ticketmaster attempts to thwart scalping, similar to governmental efforts to interdict drug flow, the more that the price actually goes up. Using simple supply and demand, assuming demand does not change, then as supply is constricted – either by Ticketmaster using its e-tickets / state laws or the DEA stopping drug flows – the price must rise. As the price of each ticket – or gram of cocaine – rises, the greater the incentive of the holder of product has to perform the blocked activity. Fortunately for Ticketmaster, concerts are not quite as addictive, and thus the price of tickets never rises to such an extent that the Medellin cartel or other violent groups will get involved in scalping, perhaps with the exception of Tupac Shakur concerts.

Leaving narcotics out of the picture (at least for now), let us examine the economics of concerts, and see the impact with and without scalpers.

Ticketmaster had the following sales and profit figures in 2008, 2007 and 2006, as reported in their 2008 annual report.

• 2008: $1.44BN revenue, $526MM (36.5%) gross profit, $954MM loss, mostly due to a major one-time goodwill impairment charge. As such, its recurring operating profit is more on the order of $140MM (9.7%).
• 2007: $1.22BN revenue, $474MM (39%) gross profit, $216MM (18%) operating profit.
• 2006: $1.06BN revenue, $426MM (40%) gross profit, $225MM (21.2%) operating profit.

It is interesting to note that their gross profit has been shrinking as their revenues have increased, mainly due to an increasing cost of sales. If we look at the accounting treatment for Ticketmaster, on page F-9 of their 2008 10K, we will see that Ticketmaster (probably correctly, but I am not a tax attorney) does not recognize the entire face value of the ticket as revenue, and then deduct the payments to the event organizer clients. Rather, Ticketmaster recognizes as revenue the portion of the ticket sale payable to it, primarily fees and perhaps any amounts paid as incentive. For example, if Ticketmaster sells a ticket to the upcoming Connecticut Bruce Springsteen concert for $104 face value, and charges a $5 handling fee, it will recognizes $5 in revenue. Additionally, if Ticketmaster’s arrangements with Bruce Springsteen’s concert organizer allows it to pay them only $94 for each ticket sold, then Ticketmaster will recognize an additional $10 in revenue ($104-94), for a total revenue of $15.

As such, it is pretty clear that Ticketmaster is not being constrained by increasing ticket price demands or squeezed margins by its clients, event organizers. Ticketmaster’s revenues have increased by 15% from 2006 to 2007 and 18% from 2007 to 2008. Clearly, Ticketmaster is selling more tickets, garnering higher fees, or both. However, its gross margins are shrinking as its costs increase. Essentially, its variable costs per dollar of sales are increasing, a bad place to be. Ticketmaster does address these cost increases on page 38 of its 10K, by stating that the increase in 2008 was due to several factors:

1. Ticketing royalties, i.e. commissions paid to event organizers as their clients.
2. Compensation and other employee-related costs
3. Other secondary causes

Interestingly, ticketing royalties increased only in line with the increase in revenues, in other words, neutral or even below the previous year as a percentage of revenue. The biggest line items, however, are the increase in employee compensation due to a 7% increase in staff, and increased royalties due to acquisitions that did not exist in the prior year. Essentially, this tells us two things:

1. Ticketmaster is using its employees less efficiently than before. Its revenue per dollar of labour cost is going down.
2. Ticketmaster has acquired business(es) whose costs of sales are higher than the acquiring unit’s, i.e. its gross margins are lower. Essentially, this is the equivalent of saying, “I have $1,000 invested in a stock that returns 20% per year. I now have another $1,000; instead of buying more of the same stock, I will buy a stock that returns only 17% per year.” I sincerely hope whoever advises this to you is not your regular investment advisor (at least going forward).

It is clear that Ticketmaster, although reasonably quite profitable in previous years at 20%+/- operating margin, and one bad year due to unusually high operating costs and a one-time impairment event, is on a trend that is slowly but definitely worrisome. The stock, which was at $25 6-8 months ago, is now languishing below $10, for good reason.

What, then, does all this have to do with scalpers? The answer will come in Part II, in the next few days. As a teaser, think of the analogy between music studios, movie studios, the television industry and Ticketmaster, all in the face of more efficient distribution channels.

On Saturday, June 13, 2009, the Wall Street Journal reported that Six Flags filed for Chapter 11 bankruptcy protection. According the to the article, Six Flags is yet another victim of the deteriorating economy. I beg to disagree.

Just under a year ago, in early August 2009, the same newspaper reported that Six Flags management had a turnaround plan. I argued at the same time that the plan was poorly constructed and ignored too many of the economic realities of the parks and, especially, their patrons. I wish I were wrong – Daniel Snyder, among others, would have saved a lot of money, and many jobs would have been saved, since the restructuring is likely to lead to trimming and layoffs – but apparently we were right.

Over the last two days, a mailing list of which I am a member had an interesting – and sometimes sharp – exchange (pun intended) about whether or not the mass availability and advanced feature sets of Web-based, corporate-focused mail services, like Google Apps for Your Domain, are a threat to, and possibly the end of, internally managed collaboration products like Microsoft Exchange. This article will provide a short analysis of the arguments in both directions and a framework for analyzing when CaaS, or Collaboration-as-a-Service, makes sense .

Why CaaS?

Why is Google Apps (or Yahoo, for that matter) so appealing to an IT manager or CFO? Normally, it is portrayed as beneficial for two key reasons, one to suit the users, the other the CFO:

1. Everywhere: If you use browser-based email or collaboration, it is available everywhere – from your home, office, laptop, customer site, even Internet cafe in Thailand. While this does not usually allow you to “leave the laptop behind,” the inconvenience, which can lead to lost business, due to being tied to a particular piece of equipment to collaborate is a significant matter for most users.
2. Management costs: With a cost of $50/user/year for premium edition and $0 (a.k.a. free) for the basic edition, the financials are extremely appealing to the CFO. In addition to an often lower cost, the ability to turn a large amount of fixed infrastructure costs into variable costs that can increase and decrease precisely linearly with the number of employees is very valuable to any CFO. It is also valuable to any CIO who understands his or her role to be COO for information, rather than chief technology manager and implementor. Unfortunately, such CIOs are all-too-rare.

In direct response to the “everywhere” issue, most internal software providers, of which Exchange is the most well-known, have provided a browser-based interface to their products. In many corporations, Outlook Web Access, or OWA, is actually the primary method many employees use to retrieve their mail. Largely, this neutralizes the anywhere advantage. Thus, the primary argument in favour of CaaS in the form of Google Apps or any other such service is cost: it is cheaper, and it is variable.

Costs

Is it cheaper?

The answer, of course, is “it depends.” Let us analyze two extremes: a small 10-person business and a large 20,000-person multinational.

1. Our small 10-person business can get Google Apps for $50/person/year, for a total cost of $500/year. By contrast, Microsoft Exchange 2007 Standard Edition is $700, plus $67 per client access license, for a total of $1,370 before hardware. Of course, the business can use Microsoft’s Small Business Server 2008 with 10 client access licenses, for a total of $1,474, around the same amount. Add in hardware for $2,000 (it will actually cost a lot more), for a total of $3,500. Since a reasonable life expectation for this equipment is the standard 3 years, ignoring time value of money, the annual cost is over twice that of a CaaS solution. Add to that the ongoing costs of power, cooling, systems administration, problem-solving, and backups, and the CaaS solution’s appeal is very strong.
2. Our large 20,000-person multinational can get Google Apps for $50/person/year, for a total cost of $1MM/year. Unlike a small company, a large firm has to deal with significant issues relating to infrastructure redundancy, cost of routing, etc. Additionally, the bandwidth demands of 20,000 people accessing email over the company’s Internet connections can be quite high. On the other hand, the large company can gain significant economies of scale in utilizing its mail servers. Assume the company has 30 quad-core Exchange servers, with 1,000 mailboxes spread over each of 20 servers on average, 5 additional servers fronting Outlook Web Access, and 5 servers in failover mode for redundancy. Since the rule of thumb often used is 1,000 average users per core, this should be sufficient. 30 Enterprise Exchange 2007 server licenses is $4,000*30 = $120,000. Add in 20,000 client access licenses at $35/license for an additional $700,000, and software licensing totals $820,000. Each quad-core server is approximately $4,000, for a total of $120,000. Assuming each mailbox to be 2GB in size, total storage requirement per server is 2TB, or 40TB total. There are lots of routes to get this storage, but assuming the least efficient direct attached storage, the additional cost will be about $6,000 per server, for a a total cost of $120,000. Thus, the total upfront cost before any corporate discounts is $1,060,000. Since the expected life of the product is 3 years, and ignoring time value of money discount rate, the annual total is just over $350,000, or $17.50 per mailbox, one third of the CaaS cost. The maintenance and staffing costs can significantly increase the total internal cost to as much as triple or more.

Thus, the raw costs of the internal route for a company of scale are significantly below those of CaaS, while those of a small business are significantly higher. To answer the first question, “is it cheaper?”, the answer depends on company size. At some point in scale, it becomes cheaper to do it in-house than out of house. My own experience shows that the point at which the two cross is actually quite high, somewhere between the 5,000 and 10,000-person mark. The primary concern is, quite frankly, how efficiently the internal IT team operates. If they keep costs low and are highly automated, then raw hardware and software costs dominate, and internal costs are much lower; if they do not, then labour costs dominate and the internal costs can match or exceed external costs.

Thus, from a costs perspective, CaaS will almost always be cheaper for small business, whereas larger institutions can sometimes save money in-house depending on their internal labour and operating costs and efficiencies. The challenge is that often costs are mixed together. The IT mail maintenance team may also support file-sharing servers; Internet bandwidth costs may be a single line item on the IT infrastructure budget; and storage costs may be subject to odd forms of fixed-cost accounting. Only an unbiased internal analysis that quickly isolates all of the costs correctly, including current and ongoing costs in both scenarios, and fully understands technology usage patterns and benefits, can correctly determine the optimal cost path.

Non-Cost Considerations

For many enterprises, however, cost is not make or break. Other considerations unique to the business operating or regulatory requirements of a particular organization or industry may have a far greater impact. In this section, we will explore those considerations and how they impact the CaaS vs. internal choice.

Budgeting

Going back to our 20,000-person company, we determined that every three years or so, on average, the firm would need to spend about $1MM in software and hardware refreshes. In most companies, these expenses would (properly, although I am not an accountant) be considered capital expenses, an asset purchase with a three-year lifespan. However, within most businesses, the process of getting OpEx, or operating expenditures, is significantly different from the cost of CapEx, or capital expenditures. Whereas an IT manager can usually get operating expenditures, whether increased or decreased, as part of the normal budget cycle plus some special approvals process at the time of expenditure beyond some threshold, capital expenditures, especially those of $1MM or more, require many more hoops to jump through. For this reason alone, if the CapEx approval and justification process is particularly difficult, there are significant advantages to CaaS, which is essentially a service leasing model. I have one client who, after several years, switched from owning and maintaining their Enterprise Resource Planning (ERP) software and hardware infrastructure to leasing it as a service. The cost financials were largely the same. However, with the lease model, the ERP manager and the CIO have converted CapEx headaches into ongoing operating expenditures. The era of capital investment battles, at least for ERP, are over.

Operating Risk

When dealing with technology services, there are essentially three layers of risk: systems, software and network. Each one needs to be managed differently and separately from a technology risk reduction perspective. However, from a business perspective, our concerns are the risk of failure and the impact on the business. Systems and software risk are identical, from the company’s perspective, whether the service is internal or CaaS. Network risk, on the other hand, differs dramatically. In the case of CaaS, loss of or significant degradation in Internet connectivity means complete loss of email service, both employee-to-employee and employee-to-outsider. In the case of internal email service, only employee-to-outsider (and reversed) is affected; employee-to-employee continues to function. The impact of this differential depends on the nature of the organization’s email usage patterns.

In most small businesses, a large proportion of mail is sent between internal employees and external customers, vendors and partners. Thus, the risk with the greatest impact is loss of Internet connectivity. As soon as the Internet connection is no longer available, or performance is degraded beyond effective usage, email essentially ceases to exist, whether the mail service is internal or CaaS. The very nature of the smaller organization size also makes it easier to work around those failures. A 10-person shop can simply use the phone, as inefficient as it may be.

In larger organizations, a larger proportion of email is sent internally between various departments or regions. Thus, loss of Internet connectivity, while painful, is not equivalent to loss of email entirely. Thus, the larger organization will suffer much greater dislocation if connectivity to the CaaS provider is lost, even though internal services continue to function. Further, the sheer size of the organization makes replacing email with phone calls nearly impossible.

Regulatory & Litigation Risk

Many businesses operate in a regulatory environment that requires them to do one or more of the following. Some companies may wish to do these for legal protection reasons.

1. Retain and/or review all emails over some period of time.
2. Keep copies of emails for some period of time.
3. Remove all copies of emails after some period of time.

Essentially, regulators of various stripes insist the company exercise different types of control over email. For example, some European countries forbid companies from ever looking at employee email, under privacy laws, while others require companies to review email for inappropriate, illegal or offensive behaviour, such as harassment or insider trading. This author is perfectly aware that these requirements may be conflicting. I once worked with a large multinational bank that operated in Switzerland, Germany and the United States, among others. German regulators forbade the bank from reviewing email; American regulators required regulators to review the emails. It was literally impossible to comply with both simultaneously. The solution required re-routing email based on source and destination in ways that they would never become part of two conflicting jurisdictions simultaneously, an absurd and expensive situation but one required by the circumstances.

Some CaaS providers can meet some of the requirements; almost none can meet all. Additionally, lack of knowledge of location of the CaaS servers and storage can open a regulatory morass, a veritable Pandora’s Box. Thus, in circumstances where conflicting and changing regulatory and litigation regimes require fine-tuned control over email behaviour and routing, both during viewing and for a time period thereafter, CaaS is unlikely to provide a viable solution for a while yet, until some CaaS provider focused primarily on these issues arises.

Privacy

Privacy is an issue for many entities. Organizations are concerned that the CaaS providers, primarily Google, but also Yahoo and Microsoft, have too much knowledge of their personal and employee behaviour. Many are reluctant to place every email they send, inbound and outbound, through servers managed and controlled by these companies. Although these concerns are legitimate, it is important to note that they are not as severe as normally raised. This is not because the companies are unlikely to mine or use email content; quite the opposite, they are highly likely to do so. Rather, it is because email that goes outside the organization, unless encrypted, is already largely public. There are no “sealed envelopes” like in normal “snail mail”,  and regulations in many countries do not equate email theft with mail theft. Further, many organizations already use SaaS mail filtering services for spam and viruses, like MessageLabs (owned by Symantec) or Postini (owned by Google). The excellent consumer and small business security company Webroot also provides enterprise services, and is a flexible alternative without being bound to Symantec’s sales procedures or Google’s mining.

Is It a Threat?

As we have shown, internally managed email and collaboration services will exist for a very long time. CaaS is definitely a threat to Exchange at small organizations, where the cost far outweighs the benefits. However, many organizations, especially large ones with complex technology, legal, privacy, budgeting and cost requirements will perform this analysis and decide they need internal email infrastructure. Exchange and its competitors will continue to be a critical product for organizations with requirements that lead to internal deployment and management. An interest proof that even Web companies are of the same mind is Zimbra. Zimbra makes a fully open-source, Web-based Exchange competitor. On October 4, 2007, Yahoo acquired Zimbra for $303MM in mostly cash and some equity. Clearly, even Yahoo, a Web pure-play business, saw the need to continue to have a presence in the internally installed and managed email and collaboration software industry.

Making the Decision

In sum, to decide between CaaS and internal email, one needs to analyze the following major factors:

• Software and hardware costs, including timing of outlays and discount rates
• Ongoing maintenance costs, including power, cooling, administration and support
• CapEx budgeting, including relative difficulty of releasing CapEx funds versus OpEx funds, and the preferred accounting treatments of assets on balance sheet
• Operating risk tolerance for network failures, as driven by email usage patterns and available alternatives
• Regulatory and litigation risk, including requirements for multi-facted and often conflicting retention, review and privacy rules
• Privacy preferences, and concern for passing all mail, internal and external, through a third-party provider

An single analyst or consultant should be able to determine these requirements for a company of any size in no more than eight weeks at the outside. If your organization does not have the staff with the mix of technology, finance, operations, legal and political skills, consider an outsider, but make absolutely sure that (a) they have all the skills and (b) they can execute quickly.

Insource vs. outsource, CaaS vs. internal, is a major decision with significant ramifications. Doing it correctly can have a significant impact on the business; doing it wrong can cost millions. Make sure to do it right.

In my experience, I have come across countless entrepreneurs who are street-smart with a real flair for sales. Yet many of them (I would not go so far as to say most, but I am tempted) regularly run into financial difficulty within their ventures. A question I have been asked time and again, as I have helped these owner/managers fix their businesses, is why so many of these talented people can start a business, actually know how to sell and recognize its importance, yet so very few can operate towards profitability?

I believe the answer lies in the single most important element in any organization or business situation: psychology. In my consulting business, the single most valuable asset is the psychologist I regularly utilize. She rarely meets a client face-to-face or by phone, yet she is capable of evaluating the behaviours of individuals with whom I come into contact and understanding what motivates them and, more importantly, how to neutralize their issues while leveraging their strengths. I have often said that a crucial differentiator for Atomic Inc is our recognition of the human element and human-focused talent. Psychology is everywhere: in human resources, in organizational structure, in sales, in marketing, in call center optimization, in just about every aspect of the business. But nowhere does it come to the fore as forcefully as in the habits and behaviours of the entrepreneur.

In many cases, the entrepreneur is someone who saw other businesses grow to millions or more in sales, and said to themselves, “I can sell that!” The pivotal word here is “sell.” Although a business must sell to generate cash and survive, the focus of most entrepreneurs, and their strength, is in sales. Put in pure financial terms, entrepreneurs are emotionally all about the top line. The method by which the top line generates bottom-line profits is often a mystery or, worse, uninteresting to the sales-oriented entrepreneur. The direct result is that the entrepreneur may get lucky and have enough sales to cover costs, or, in most cases, they may run a business that loses money not only for them, but also for their equity and/or debt backers. Without a solid grasp of operations and the numbers, the entrepreneur cannot:

• Determine what the business’s costs should be at any given level of revenue
• What the right mix and fixed and variable costs is
• How variable profits actually are, and plan accordingly
• Set targets to determine if the business is succeeding, even on the revenue side alone, and adjust plan to suit
• Determine cash requirements for survival
• Gain confidence of lenders and investors
• Manage inventory to avoid unnecessary purchases, which has a very real cost, or under-purchasing, which leads to last-minute premium-priced stocking, along with lost business or even repeat business and negative reputation
• Determine which if any initiatives are good investments and which are just a distraction or, worse, a waste of precious cash
• Survive

The short form is that business is about profits, profits are about revenues minus costs, inventory is about systems and discipline, and without numbers, a business is highly likely to fail.

The real challenge is that sales, not numbers and operations and financials, is in the DNA of most entrepreneurs. The question that has been raised time and again, including recently by a banker who asked me for ideas as to how to reform an entrepreneur, is how to change the behaviour sufficiently to turn a business around.

The solution is fourfold. Entrepreneurs, repeat after me:

1. “I have a Problem”: The entrepreneur must recognize, if only for a short time, that, like any addict, s/he has a problem. They are great at sales, but if they want to make money and grow a successful business, they have a shortcoming that must be addressed.
2. “I need help”: The entrepreneur must get help. An expert in operations need to be able to show the entrepreneur how much money they could be making, dangle it in front of them, get them to salivate. The one thing that will get an entrepreneur more excited than sales, is actual cash into his/her pocket. The cash comes from profits.
3. “I need method”: The entrepreneur must be given a system that suits their personality as best possible. Don’t expect a sales-oriented entrepreneur to do QuickBooks, Microsoft Dynamics, or PeopleSoft every day, let alone manually handle the numbers in a spreadsheet. The manager needs a system that is minimally invasive of their current structure, yet provides significant additional insight.
4. “I need accountability”: The entrepreneur needs his or her feet held to the fire. This is done in two ways. First, the expert must walk them through the process, going over the numbers with them as often as possible (daily, weekly, whatever is appropriate for the situation), until the owner begins to see the benefits and can stand on his/her own. More importantly, there must be tangible benefits. Investment tranches, subsets of an entire investment given to the business at predefined times conditioned on achieving well-defined milestones, are an excellent method used by venture capitalists the world over. I have personally advised bankers to use this method. Give the entrepreneur enough funds to get to the next milestone, but condition the next tranche on placement of a cost- and inventory-management systems.

The great challenge is often to get the entrepreneur to agree to change, and ease into the change until it becomes true habit. The balance of support between help from the expert combined with conditional financial assistance from investors can go a very long way towards the behavioural modification necessary.

According to press reports making their way around mainstream news organizations as well as the blogosphere, IBM is making a play to acquire Sun Microsystems. The initial advantages appear to be straightforward. IBM rules in the East, old-school; Sun is a major player in the West (although their Silicon Valley neighbours, H-P, sell far more hardware, especially since the Compaq acquisition). IBM’s strength is mostly in big, heavy, hardware, with proprietary systems around them, including mainframes and its distributed systems (which, for those of us who have worked with them, look and behave suspiciously like repackaged mainframes) and its huge consulting arm IBM Global Services (IGS). IBM has a robust software business, mainly focused around its database (DB2) and application server (WebSphere) as well as several other middleware pieces. Sun, on the other hand, tends to develop leading-edge, dynamic systems and software. It is the major force behind Java, the top enterprise-class development language, offers everything from low-cost “pizza-box” sized light hardware running AMD and Intel standard chips to its own high-end multi-processor multi-core Sparc-based systems.

The differences between the two can be summed up in their histories. Ten years ago, Sun said, “we put the dot in dot-com”, while IBM could have been called, “we put the red tie on the blue suit”. The history of how the Sun storage appliances came to be is particularly instructive. Several senior engineers went to a senior executive at Sun and said, “We invented NFS (the protocol used for most network attached storage devices, like those sold by NetApp), we have the best hardware, we are open across the board, why aren’t we players?” The executive approved the program on the spot; two years later, the appliances were out on the market. This type of thing could never happen at IBM. Sure, it might get approval for preliminary market and sales research after several rounds of executive committee meetings, and the huge and influential sales organization might or might not approve, but Sun is innovative and on the edge; IBM is conservative and on its seat.

The old line is that “no one ever got fired for buying IBM”. This is true, which is why big health-care organizations still buy lots of IBM. I recently worked with a large health system that insisted on buying IBM servers, despite a fully-loaded cost of purchase, deployment, maintenance and application conversion of twice the alternatives (Sun or Linux, both of which were explored and priced out), and a feature set that was about 30-35% less than their base requirements. On the other hand, small firms, start-ups, and even the financial behemoths of Wall Street (which, one might point out, essentially no longer exists), were never worried about a bureaucratic existence and “no one ever got fired”. They were, and remain, far more interested in getting the job done as efficiently, reliably and cost-effectively as possible. IBM never competed in this space. I will say it again. IBM never could and never did compete in this space.

So what are the prospects of this proposed acquisition?

1. It doesn’t go through. Even if the IBM and Sun executives and Directors can come to terms, I would put it at 50/50 that shareholders will approve. On the other hand, Sun shareholders have tolerated directors and management that have left Sun’s stock to bounce up and down like a yo-yo over a multiyear period. Sun is currently languishing at 1/6 the price of just two years ago.
2. It goes through. If it does, expect IBM’s famous bear hug to kill Sun. IBM has bought itself market share in many sectors before, squeezed the company, and killed the goose that lays the golden egg. Tivoli, Lotus, the list goes on. These were all great companies at one time. IBM bought them, integrated them to the “big blue” culture, and they remain withered on the vine. In the meantime, IBM has had somewhere around zero real innovation on its own all of these years. Yes, it has made major advances in its R&D labs, but has brought little to none of it to market. ZFS is the first major filesystem innovation in decades.

Either way, Sun shareholders are losers, and have been for several years. Scott McNealy was a colourful character, crazy in a positive way. To be fair, he did nearly kill the company when it got completely blindsided by the arrival of commodity hardware and Linux. However, Jon Schwartz, who managed to recover from that phrase – I attended his “Sun on Wall Street” presentations back in 2003 when he attempted to woo back many of his former bread and butter customers – has bungled it to this point.

Sun has an enormous amount of potential value locked into its franchise. IBM will not unlock it, it will crush it. On the other hand, if the deal does go through, expect many senior and talented Sun staffers to leave, if not immediately, then shortly after some next equity/options vesting milestone. Many of these will start new companies that will compete directly with what IBM (the company formerly known as Sun) does and was planning on doing. These companies will be more nimble, will succeed, and will eat IBMSun’s lunch while the people left at IBMSun desperately beg the “boys in blue (suits)” to give them an answer to the small proposal to do the same thing… that has been in committee for 24 months.

In any business, in any setting, security is about trade-offs. It is about trading the inconvenience of process for the (supposedly) improved security that is necessary. For example, even the President of the United States is undoubtedly annoyed that he cannot go out for a walk without having the Secret Service clear it, but accepts the inconvenience as necessary to protecting his life. On the other end of the spectrum, everyone who has travelled in the United States in the last eight years is painfully aware of the inconvenience of the Transportation Security Administration (TSA) agents performing scans ranging from metal detection to show removal to full-body searches; whether or not this actually improves security is subject to debate. Shortly after 9/11, the former head of security for Israel’s airports visited, and commented to the effect that the United States does not have a passenger security system, it has a passenger inconvenience system.

In a business, there really are two kinds of security to take into account: physical security and information security.

Physical Security

Physical security is security of premises and persons of the institution. Thus, the White House has the Secret Service, the Capitol has the Capitol Police, and just about every office building in Manhattan has a security desk and turnstiles. This security may extend outwards. Thus, key personnel may have guards (I once worked for a man who never went anywhere without an armed escort). At times, it can be quite entertaining. Years ago, I worked at a firm that brought a senior Netscape executive to speak. He had a security detail almost as large as the President’s.

Information Security

Information security is the security of the information in the hands of the institution. Although the term “Information Security” or “InfoSec” is normally used to apply to the security of digital information, such as that stored in a company’s databases, the term technically applies to all information, including that in file cabinets and desks. However, since physical information such as papers and folders is only at risk within the confines of its physical location, information security is normally applied to digital assets. Information security is a unique discipline and is particularly challenging, for several reasons:

1. Ease of Reproduction: Digital assets can be reproduced at what is essentially zero cost, and without disturbing originals. Thus, if someone steals account information, the original is never disturbed. The Internet itself has been described as the greatest copy machine ever created.
2. Ease of Access: Unlike physical assets, which require physical access to premises in order to access the information, digital assets can be accessed without ever going near the physical premises. Every day, millions of people purchase items from Amazon.com, without ever setting foot in Seattle, let alone Amazon’s facilities.
3. Expected Convenience: For good reason, most people expect computer systems to make their lives and jobs easier and more convenience. The very notion of systems that inconvenience them runs contrary to their expectations, and thus makes behavioural changes extremely difficult.

Trade-Offs

Of course, the need for security creates the previously discussed trade-offs. Many businesses, especially those with highly sensitive data or regulated data, such as credit card information (PCI) or health records (HIPAA), require those who desire access to internal records to use a virtual private network (VPN) and some form of one-time password, such as RSA SecurID tokens, to access corporate systems. The inconveniences are multiple:

• It is much easier to just connect to a system than to open a VPN application, connect and log in to that, which often precludes direct access to other, non-corporate systems, while connected.
• These one-time passwords are inconvenient, require a physical item to carry around which, if unavailable or lost, mean inability to access systems.

Despite the inconveniences, many corporations and, in the case of HIPAA or PCI, regulations, require usage of these security systems. The cost is not insignificant. A single VPN concentrator (the term used for the system that allows users to connect to a VPN), one-time password server, and tokens, can cost thousands of dollars for a few users, in addition to thousands of dollars in implementation costs. If the business systems are mission-critical, then reliability means multiple redundant systems, possibly in multiple locations, which can increase capital costs 3-4 fold, and implementation costs by a similar order, depending on systems complexity. Finally, in all cases, there is the hidden cost of the employee/customer/consultant time in accessing the system. Assume a field salesperson who is compensated $100,000 per year, with benefits adding 30%, for an average hourly cost of $65/hour. If they need to access the systems twice per day, at 250 business days per year (according to the US Department of Labour, that is 500 accesses per year. If the inconvenience adds “only” 5 minutes per connection on average, that is 2,500 minutes lost, or 42 hours, for a total cost of $2,708 per year. This salesperson just lost 2% of their productive time, at company expense, of course. Add to that the downtime when the VPN and login systems are inaccessible, or the salesperson cannot find their access token, and the costs go up dramatically.

Reverse Trade-Offs

The most interesting cases can be found when a “reverse trade-off” occurs. In these cases, the organization actually makes it harder to become more inconvenient, for no good apparent reason. Put in other terms, they make it more inconvenient and more insecure, at the same time. These are usually indicative of poor security within the institution itself.

I recently received an email from a reporter asking me to help them on behalf of a reader. Apparently, this reader is an online banking user, like the majority of those reading this article. The bank had limited the customer’s password to 6 characters. Yes, in this day and age when social networking sites with no private financial information require at least 8 characters, a bank was insisting on no more than 6. The reader, who, justifiably, wanted more security and a longer password or passphrase, was interested in understanding why the bank did this.

In the case of this bank, it is highly likely that it is one of:

• a very long time ago, someone created a system that only used 6-character passwords
• the customer account is being mapped directly to a login account on, some system, given the password-length likely an older mainframe, which speaks poorly of their application design, as well as their account-security and management procedures
• the least likely but most disturbing, the bank decided that the cost of password resets is simply too high, and force easy, simple passwords, with just 6 characters, and have thus consciously chosen convenience over security

Either way, we are dealing with ignorance or incompetence. Either way, this is highly likely the tip of the iceberg, and indicative of very poor security measures internal to the bank, and indicative that they are probably spending far more money for far less security, as well as other back-office operations, than they should. Either way, don’t trust your information to this bank.

My colleague, Jonathan Vanasco, has written an excellent piece on web-based business P&L operations & optimization. I have had the honour of contributing feedback to the piece.

I strongly recommend reading it here.

Recently, I had the pleasure (take that with a grain of salt) of discussing, with several colleagues, the pros and cons of taking venture capital investment. Everyone seems to have an opinion. I have seen articles published that VCs are the unsung heroes of modern American capitalism. I have seen others that vulture capital would be a better term.  Interesting how the world shifts.

Until the 1980s or even early 1990s, pretty much no one outside of the business knew what venture capital was, how it worked, or where to get it. Then came the Internet boom. Of course, numerous VC-backed firms had had successful exits long before that, making some VCs and founders quite wealthy, but the scale and speed of the Internet boom in the 1980s brought it very much to the public eye. Add some VCs driving their Lamborghinis (plural) around town, and suddenly everyone wanted to be VC-backed, if not an actual VC.

In 2000-2001, the whole thing crashed. Then, everyone believed VCs were terrible, money-losing, and would make you lose your business to boot. Then came social media, the whole concept of “eyeballs” actually began to make money with online advertising, and VCs had a big comeback.

In the 2007-08 recession, it all seems to have turned around.

The real question is: who are VCs, and are they good or bad for your business?  

In true engineering fashion, the answer is, “it depends.”

The VC Business Model

Let’s look at the VC business model, and then we will have a better understanding as to how they fit in. Venture capitalists are a niche of private equity. They are in the business of taking other people’s money, usually large institutional funds like Calpers or Duke University endowment but sometimes very wealthy individuals, and investing it on their behalf to earn outsized returns. The value the VC brings to the investor is their supposed ability to filter among the thousands, millions of potential early-stage private investments, determine which mix of business plan and team is most likely to be successful, and put money into the firm in exchange for equity.

The VC – and by extension the investors – get their money back when the “exit” occurs. The exit is a liquidity event, something that allows the investor to turn their privately held illiquid stock in the firm into a liquid form, usually cash.  There are normally two kinds of exits:

1. IPO: The Initial Public Offering. The firm lists itself on a public stock market – historically in the US this has been the Nasdaq for tech ventures, although others have listed on the NYSE, while others overseas list on the Deutsche Neuer Markt, the London Exchange, etc. –   and the investors can now sell their stock to the public. This exit has been in severe decline in the last decade. This is primarily due to two main factors: litigation, by which public companies and their directors and officers personally are sued for a decline in the stock price; and regulation, particularly the Sarbanes-Oxley act, and its notorious section 404, which dramatically increased the regulatory burden of being a public company. In response, most new firms have avoided the IPO as their stated exit. Others have chosen to list overseas to avoid the double-squeeze of US litigation and regulation.
2. Acquisition: The firm is acquired by an existing firm, for some mix of cash from the acquirer’s reserves and stock of the acquirer, which is likely already publicly traded and is thus liquid.

In other terms, the VC puts its money into the firm, fully expecting that at some point hence, normally 5-7 years, it will receive many multiples of it back in a liquid form. The VC will do everything necessary and within its power to move the firm towards that exit.

Of course, most new ventures fail, many within 1-2 years. The riskier the venture, the larger the market, the greater the probability of failure. To compensate, the VC must invest in lots of firms. So, the VC makes an assumption. For every 10 firms: 7 will fail, 2 will be going concerns but not worth very much (by the VC’s standards), and 1 will be a star. Thus, to make sure that the one star really does shine, and make up for all of the rest, the star must be worth $1BN, and thus must be in a $1BN market.

Result: It is in the VC’s interest to drive every firm in its portfolio to get as big as fast as possible. It doesn’t want successful firms; it wants hugely valuable firms. If that means that all 10 firms take outsize risks, so be it. One will succeed, and that is all it needs.

The VC’s Compensation

In general, the VC is compensated with two elements:

1. Management Fee: Each year, a certain percentage of the money committed to the VC is paid out to the VC’s firm as a management fee. In the VC world, it is normally 2%. Thus, if the VC has raised a $10MM fund, he can expect to receive $200,000 per year as a management fee, which covers everything from legal expenses to accounting to office space to salaries. It is easy to see that a small 3-partner VC firm requires a lot of money under management just to get by. 
2. Upside: When the VC returns money to its investors, it shares in the upside. Sometimes it is after a certain minimum return, sometimes it is before or after the management fee, but the general rule of thumb is to share in the upside. Thus, if a $100MM fund returns $130MM, the VC takes $6MM and the investors take $24MM, ignoring the effects of minimum return, management fees, etc. It is important to note that the VC does not share in the downside. Thus, if the $100MM fund loses money and ends up at $80MM, the investors take the entire $20MM loss.

This management fee plus upside model is very common in private equity, of which VC is a small niche, and is almost non-existent outside of it. In general, most US regulation disallows upside sharing for publicly available investment vehicles, e.g. mutual funds. This structure is normally expressed as “management fee / upside.” Thus, the VC model is normally described as 2/20.       

The Founder’s Model 

The founder of the firm, on the other hand, is putting all of his or her life’s energy into this one firm. He wants this firm to succeed, and may be willing to take fewer risks than an investor. He may or may not be satisfied with a $20MM valuation, whereas the VC wants a $1BN or higher valuation. The founder cannot diversify away his risk the way the VC can.

So What is the VC

The VC is a businessman, like any other. He is usually financially savvy, often strategically savvy, and infrequently but sometimes understands operations and execution. It is also usually a he, not a she, for reasons that I do not fully understand. It is unlikely to be any form of discrimination; many of these VCs hire high-powered extremely capable women to run their companies, like Meg Whitman of eBay, Carol Bartz of Autodesk (now at Yahoo) and many others.

The VC has his or her own interests and needs. His model is built around certain assumptions about diversification, risks, size and speed, and he has certain expectations. There is nothing wrong or right, good or bad, with his model and interests. It just is, however, the model the VC has chosen.

When to Take VC Money

By this point, the answer should be fairly straightforward: take VC money when the founder’s interests and the VC’s interests align. If the two do not align, then chances are strong there will be a nasty falling-out at some point in the future. Charles de Gaulle was famous for saying, “countries have no friends, only interests.” The same should be said for VCs.

The overwhelming majority of new business ventures that are founded start off as, and intend to grow as, small businesses. Of the rest, many have a maximum intended growth of a few $MM to a few tens of $MM over many years. A few, a very few, are intended to be game-changers: Google, Amazon, Intel, the kinds of companies that change the face of an industry, if not the world.

If you are building a company that intended to change an industry or the entire world, and in order to succeed you must get very big, reasonably fast, and are thus willing to take very big risks, go for the platinum ring, then VCs are the right vehicle for you. Even if you get funding, 70% of the time you will fail, 20% you will sort of hang on, but the last 10% will be home runs. 

On the other hand, if you are looking to build a successful small or midsize business, intending to grow a decent market share and have solid revenues and profits, but do not want to risk the whole thing on a single throw of the dice – go for the brass ring or silver ring, rather than the platinum – then VC is not for you. There are plenty of other sources of capital – angels, friends and family, banks, SBA, the list goes on – that are much better suited. If you approach the VC, and especially if you take their money, you are doing a disservice to everyone: your investors, your friends, your employees, your customers, your VCs and most especially yourself. Fortunately, many VCs are very sharp, some of the smartest people I have met (but not all) are VC partners, and they will winnow out the ones that do not suit their model. But sometimes they will see one that can fit their model very well, even if the founder does not. It is in their interest to find and invest in these companies. If you do not want that growth, risk, size and relationship, do everyone a favour and stay away.

Clearly, the United States (and much of the rest of the world) is in a recession, and has been for some time. Opinions differ greatly as to how long the pain will last – some say weeks, some say months, others years (and some say decades unless we adopt their solutions, whatever they are) – but it is clear that corporate revenues have dropped significantly and the pressure on profitability has increased dramatically. This article proposes to explore the various types of cost-savings and cost-cutting available, and draw some lessons. These are applicable to all businesses, but have some special resonance for small to midsize businesses.

In general, there are four overall types of cost-savings that can be performed. Each one is appropriate for particular circumstances, some are better short-term, others are better long-term. Do not implement any of these without taking a serious assessment of what your short-term and long-term goals, revenue projections, competencies, competitive landscape and cash flows are. 

1. Reduction: Reduction is quite simply the process of reducing the number of inputs to your process. This can take the form of selling off manufacturing equipment, buying fewer chairs, or, in its most common form, layoffs (i.e. reducing headcount). In many ways, this is the most painful – you are hurting real people with real needs, especially with headcount reductions – but it is also the most simple for CFOs and CEOs to figure out: “We have $10MM per year in labour expenses, if we lay off 20% of our staff, we will save $2MM.” Reduction is most appropriate when gross units of sale have dropped, or are expected to drop, and the reductions are performed on the variable cost inputs. Thus, if your business sells hammers, and you expect to reduce sales from 2MM hammers to 1.5MM hammers this year, it would make sense to reduce the amount of handle-quality wood purchased by 25%. Similarly, if you sell consulting services or investment banking services, both of which are human labour intensive activities, and you expect a reduction in service revenues of 20%, it makes sense to reduce the labour inputs to these services by 25%. In those circumstances, and normally only in those circumstances, do direct reductions make sense. Unfortunately, this is often too simplistic, the refuge of executive simpletons. Obviously, if the marketing or sales departments are overstaffed, by all means they should be reduced, but that is not restricted to lean times. Reducing marketing or sales by 25% just because every other department is getting hit is akin chopping off your leg because it needs to give its fair share when getting a haircut. In these times, driving up sales – which is what marketing and sales do – is exactly what the company should focus on. Similarly, R&D, which focuses on new products, may be crucial. While everyone else is cutting back on these “not today” investments, targeted marketing, sales and engineering investments will put the smart company in a position to leap ahead of competitors during the downturn and especially as business picks up. The only time that cutting back on these areas make sense are when the business is in survival mode. Specifically, if cash flow is so tight that not cutting back will leave the company short of necessary cash to survive. In that case, any cutbacks that allow the business to survive to fight another day make sense. But as a general rule of thumb, when someone utters the phrase, “business is down so we are laying off across the board,” or the more pernicious, “the other departments are cutting so you have to as well,” you know you are in the presence of a poor businessperson, failed executive and ineffectual leader. Across-the-board reductions are too often the “refuge of scoundrels.”
2. Pricing: Pricing is purchasing the same quantity of inputs – labor, telecom, real estate, office chairs, coffee, whatever – but at a lower unit cost. This normally comes from renegotiation or consolidation (i.e. economies of scale) of purchasing. Quite simply, it is a lot cheaper to buy office chairs in bulk for the 500 staff spread around 10 offices, than for each office manager to go to Staples or wherever and pay retail. Like the reductions in bloated departments, these are cost reductions that should be performed at all times, flush and lean. Unsurprisingly, most organizations do not look at these issues during flush times, focusing much more intently on growth. The few businesses that do tend to be those whose market strategy is to focus on being cost-leaders, like Dell or Wal-Mart, and thus are constantly looking to squeeze every extra dollar (or penny) out of costs. Companies should always look to save in this area. However, a quick assessment upfront should help determine if the savings are realistic. This assessment should come as part of an overall cost-savings analysis, and should not cost significant extra sums. Unless your firm spends millions of dollars a year on telecom, there is no way a telecom consultant at many thousands of dollars is going to have a significantly positive ROI. 
3. Efficiency: Efficiency means running your organization with fewer inputs for the same outputs. Some of the efficiency may lead to repricing or reductions. However, unlike reduction, where the goal is to reduce inputs to match reduced outputs, the goal with efficiency is to reduce inputs while keeping the same level of outputs. The flip side of the coin is the ability to increase outputs without linearly increasing inputs. For example, a business may look to take advantage of competitors’ challenges during a downturn by increasing customer service levels. However, due to the downturn, it cannot afford to spend the additional 20% in investment required. If the customer service organization can improve its efficiency by the same 20%, it will have the additional capacity to increase customer service levels by 20% (actually, more like 25%) without a concurrent increase in costs. Efficiency gains come from several areas:
   • Real estate: A good architect or designer can reallocate space usage so that less real estate is required, thus reducing costs, without reducing usable space. Unless a business has significant real estate costs, normally the province of larger organizations or those with large physical plant, this is unlikely to yield outsize returns.
   • Organization: An organizational structure that is best suited to the activities and process flows of the organization, along with the proper incentives to do what best benefits the organization, not just the individual, can yield significant benefits. 
   • Skills alignment: Skills and their requirement vary by role within an organization, as do the labour costs for those skills. Rarely do organizations reassess their structures in light of skills requirements and costs. In the last year, I worked with an organization where $100,000 per year engineers were performing all the roles of a general support organization: telephone support, first-level support, second-level support, outage management and toolset design. Some of those require $40,000 per year staffers, others $150,000. Half the time the engineers were bored, the other half in over their head, and customer service failed throughout. Putting the right kinds of staff in the right roles, along with the processes required to support them, saved a $10MM organization upwards of $3MM per year while increasing service levels by double-digit percentages.
   • Transaction processing: Technology-driven transaction-intensive processes demand large amounts of infrastructure investment. Restructuring the transaction flows so that they are as efficient and optimal as possible can lead to outsized savings. The most recent Inc magazine (Jan/Feb 2009) has a cover article on PlentyOfFish.com, a dating sight with over 1.5BN page views per month, all database driven, with only 8 servers and 4 staff. 
4. Finance: Efficiency in the back-office can lead to significant financial savings. Unfortunately, back-office processing, especially finance department activities like accounts receivable, accounts payable, payroll and expense processing, are normally given short shrift and treated like the poor sister. Improving efficiency in these areas not only can improve the operations themselves, but also can have a strong impact on the finances of the organization. I recently examined a large food retailer, which, despite many millions per year in sales, still does inventory management by walking through the facilities. As a result, their inventory turns were low and their wastage write-offs (not to mention the infamous “shrinkage”) were high. Yes, improving the efficiency of taking inventory saves on direct costs of labor, paper, pen (or laptop). But far more importantly, it allows the firm to increase its inventory turns, reducing carrying costs, and reduce write-offs, improving the bottom line of the business without a single additional dollar of revenue or reduction cost-savings. Another organization I worked with had accounts receivable issues, leading to slow A/R to cash turnaround times and a certain percentage written off. A longer series of articles about this is available on this blog site.

Given all of these major ways to improve the bottom line, even during lean (or painful) times, how does one find these? How do you know when you are cutting fat rather than meat or bone? And more importantly, how do you know when to cut, when to invest, when to improve? Here are some rules of thumb:

1. If cash flow problems leading to immediate survival is your issue, do everything you need to survive. Try hard not to survive today just to die tomorrow, but if the alternative is going under today, do what you need to. 
2. Once immediate survival is not the question, you have some room to maneouvre.
   1. Look for low-hanging fruit, any area where efficiencies can be gained rapidly and obviously. This not only helps you gain some more profits, it builds credibility within the organization that you are trying to improve, not just cut. A major side-benefit to efficiencies is that once they are implemented, most employees’ lives get easier. They look forward to it. 
   2. Look for pricing opportunities, but do not expend too much effort. If you can save $1MM per year on telecoms costs, then likely you are already a billion-dollar+ revenue organization. There are easier ways to save money, most of which will lead to a lot more than $1MM in savings. Go for the obvious easy ones, and rely on your overall efficiencies consultant to find them for you, rather than paying extra for someone else. If the opportunities are there, s/he will quickly get you a good person to renegotiate, if relevant.
   3. Drive your efficiencies up. Most of your savings and your ability to survive will come from these. 
   4. Use your improvements to improve your market position. If you used to have Dell-quality customer service and now have HP-quality, make sure every single one of your customers (and potential customers) knows it. You were looking to save money; you gained a competitive advantage in employee satisfaction and customer service on the way. 

The devil, of course, is in the details. Knowing what to do, how to do it, gaining perspective when you are busy 24×7x365 running the business, seeing the cross-silo and cross-function picture, and getting around the politics that even small organizations have is challenging in the best of times. During the stresses of a downturn they are all amplified. Unless you have someone on staff who specializes in this, get outside help. Big consulting firms will cost a lot; personally, I have always found it ironic that a firm selling efficiency analyses will use 5 consultants, at $2,400 per day for 3 months… to help you save money!

There are better ways. but there are good boutique firms, tailored to your size, that can perform analyses like these in a matter of weeks and minimal cost. Atomic Inc was built around these principles.

In the previous article, we laid out the main areas in which the efficiency and effectiveness of operations within a fairly small back-office finance department can impact the bottom-line. In this follow-up article, we will see just how severe the impact can be through a case-study, complete with actual numbers.

The Patient

The patient, firm X, is a $15MM annual revenue firm, so larger than a start-up, but still on the small side. All of the firm’s revenues come from professional services, with an average hourly billing rate is $110, giving 136k hours billed per year. As a professional services firm, its primary costs are labor expenses to the staff who work on billable projects, both salaries to employees and payments to contractors. Using the US Department of Labor standard of 2,000 labor hours per year, the firm uses 68 person-years to deliver its services. The firm has 25 billable employees with a fairly high utilization rate of 80%, or 1,600 hours per year. The rest of their time is spent on training, development, non-billable travel and paperwork. The total billed by employees is 40,000 hours per year, or 29.4% of the firm’s total revenues, with the remaining 96,000 or 70.6%, billed via contractors. The average billing per contractor is 700 hours per year.

The 25 employees cost the firm, on average, $100,000 in salary and benefits per year. Since each employee bills out 1,600 hours per year, for revenue of $176,000, the gross margin per employee is 43%. The average rate the firm pays its contractors is $80/hour, for a gross margin of $30/hour or 27%. Clearly, contractors are much more expensive than employees. However, the firm is subject to two forces that limit the use of employees.

1. Demand fluctuates greatly. Although the firm can reasonably expect to hold to its $15MM in revenues, it wants to keep its fixed costs down, and thus does not wish to be subject to layoffs when business takes a short or medium term downturn.
2. Demand is geographically dispersed. The firm cannot always expense travel costs and times to its customers. Thus, it uses contractors who may only bill 500 hours per year to the firm, but will be much closer to the customer.

Average gross margin for the firm is 27%*70.6%  (contractors) + 43%*29.4% (employees) = 31.7%. With $15MM in revenue and 31.7% average gross margin, the firm has $4.76MM in annual gross profit. Of that $4.76MM, $3MM should pay for various overhead – real estate, accounting, legal, and administrative, including, of course, the finance department. The remaining $1.76MM is operating profit that either goes to the shareholders as dividends or is reinvested in the business.

Back-Office: The Finance Department

The finance department is staffed by 5 people: a CFO and 4 employees. Its average invoice size to customers is $20,000, so it issues 750 invoices and receives an equal number of payments per year. It does no material business via credit cards, and most of its invoices are issued net 45, as is common practice in its industry. The average invoice received for payment to contractors is $2,000, so it pays 3,840 contractor invoices per year, in addition to invoices for basics such as real estate, consumables, bank interest, etc. Employee salaries are paid twice monthly, on the 15th and 30th of each month. Employee expenses are reimbursed at the “next available pay cycle,” which employees understand to mean the second paycheck after approval, or 5 business days plus 2 paychecks. Thus, if an expense is submitted on the 1st, the employee expected to get paid on the 30th, whereas one submitted on the 10th is expected to be paid on the following 15th. Employee expenses consist primarily of travel expenses to customers and training materials, as well as mobile phone bills. Consumables and other incidentals are paid directly by the firm to vendors.

The Issues

Let us examine each of the issues raised, and the cost to the business. 

Payroll

As a small business with 25 employees, some sales people and executive staff, and the 5 people in finance, total regular payroll is 40 people, a fairly small operation. Payroll has been outsourced entirely to SurePayroll. One of the key advantages to SurePayroll is that it sends out reminders to process pay on a regular basis. Thus, X almost never misses payroll and is rarely, if ever, late. Employees like SurePayroll as they can pull their entire pay stub – and its history, as well as end of year tax forms – online. 

Expense Processing

Expense processing is handled by submission to the finance department in a paperwork process. Receipts are attached to paper using Scotch tape, along with printed or handwritten expense reports. The average employee submits $200 per month in expenses. The employee pays the expense out of their own pocket, then awaits reimbursement. The reimbursement is manually entered into the SurePayroll pay stub with the appropriate billing cycle.

Because of the slow paperwork process, the following occurs:

• 25% of expenses are submitted at least two weeks after occurrence, while the remainder are submitted end of the same week. 
• 15% are lost and must be resubmitted. However, without any method of employees tracking the status, it is only once an invoice has failed to be paid do employees know of the lost expense and resubmit.
• Expenses are normally actually reimbursed three pay cycles after submission, rather than two. 

With 25 employees submitting one expense sheet per week, 100 are processed per month. Each expense submission requires 15 minutes of employee time, and 15 minutes of finance staff time, for a total of 3,000 minutes, or 50 hours. At the fully loaded cost of $100,000 per employee shown earlier, direct basic expense processing costs are $2,500 per month or $30,000 per year.

Lost invoices require one hour of employee time and one hour of finance employee time, or two hours total. With 15% lost and requiring resubmission, that is 15 per month, or 30 hours per month, 360 hours per year. At the fully loaded cost of $100,000 per employee, reprocessing of lost expenses is $18,000 per year.

Slowness of paying means that each employee is out, on average, $400 awaiting reimbursement at any given moment. At consumer unsecured debt rates of 15%, each employee is paying $60 per year to finance the business. From the employee’s perspective, however, all that they see is $400 in cash they need to carry for the business. As word has gotten around as to the slowness of paying of expenses, each new employee has insisted on a salary at least $400 per month higher than they would otherwise accept. This is an additional $5,000 per year per employee cost. With 25 billable employees, the cost to the business is $125,000. 

Total expense processing cost is $171,000 per year. Total cost due to late and missed payments is $141,000 per year. Average labor cost per basic processing is $25; this should be between $10 and $15. Cost due to inefficient process is $10-15,000 per year. 

None of these costs takes into account employee turnover and the cost of retaining new employees, which will not be calculated here.

Summary:$156,000 per year in direct waste.

Invoice Processing & Accounts Payable

X spends approximately $3.0MM each year in overhead. $500,000 of that overhead is the finance department, including benefits. Although slow accounts payable affects many vendors, we will focus on one area alone: consultant invoices. As described above, contractors bill the firm 96,000 hours per year. The average rate for contractors is $80 hour, for total billing of $7.68MM. These invoices are all due net 30. However, X loses approximately 15% of the invoices, a rate identical to the lost expense rate. Each lost invoice requires tracking down to ensure that it is truly lost, and then resubmission.

As stated above, 3,840 invoices by contractors are submitted per year, with each contractor performing, on average, 700 hours per year. The time to process invoices is similar to the time to process expenses, 15 minutes of finance department time and 15 minutes of contractor time. Due to the standard terms and conditions with contractors, the 15 minutes of contractor time is not billable. With 3,840 invoices and 15 minutes per invoice, basic invoice processing takes 960 hours per year, or $48,000 in costs. 

Lost invoices take one hour to process, including resubmission, if necessary. At 3,840 invoices per year and a loss rate of 15%, 576 invoices must be reprocessed at an hour of labor each, for a total cost of 576 hours or $29,000. 

The single largest element, however, is the increase in rates. Because the firm is known as one that pays late and frequently loses invoices  - and all contractors who do not know initially, find out very quickly – X is paying above-market rates for each contractors. The rate for this type of contractor is between $70 and $75 per hour. The $5 to $10 increment in rates is demanded by contractors to cover lost hours in following up on invoices as well as late payments. Since contractors bill 96,000 hours per year, the firm is paying, at minimum, $480,000 in excess fees, directly reducing its gross margin.

Summary: $509,000 per year in direct waste.

Invoice Issuance & Accounts Receivable

As stated above, X receives $15MM in revenue, spread over 750 invoices, each with an average amount of $20,000. Like X, most of X’s customers have a “must invoice by y days after service” policy to be paid. On average, the policies provide for full payment if invoices are received within 30 days of service, 10% penalty for invoices received within 60 days, and option to refuse to pay for invoices received after 60 days. X does not have a structured invoice issuance and follow-up process. Almost all of X’s invoices are issued net 45. The distribution for invoice issuance is as follows:

• 60% of invoices are issued within 30 days
• 30% of invoices are issued within 60 days
• 10%  of invoices are issued after 60 days, of which 3/4 are accepted with 15% penalty and the rest are rejected

Additionally, 25% of invoices are not paid within 45 days, but rather once finance personnel follow up, leading to payment within 75 days. Each invoice follow-up takes one hour of finance staff time. With 750 invoices per year, and 25% paid late, 187 invoices are late, costing 187 hours of employee time or $9,375.

The cost of late invoices is as composed of two components: reduced or lost revenues, and cost of carry. For simplicity sake, we will ignore cost of carry.

• 60% issued on time: no costs.
• 30% issued within 60 days: 10% * 30% * $15MM = $450,000
• 7.5% issued within 90 days but paid with 10% penalty: 7.5% * 10% * $15MM = $112,500
• 2.5% issued within 90 days and rejected: 2.5% * $15MM = $375,000

Summary: $937,500 in annual costs. 

Reporting

Cash management and reporting will not be calculated at this stage.

Summary

Total avoidable annual losses from suboptimal finance department management are as follows:

• Expense Processing: $156,000
• Invoice Processing and Accounts Payable: $509,000
• Invoice Issuance and Accounts Receivable: $937,500

Firm X is losing $1.6MM in direct profit each year due to the poor performance of a small back-office department. Recall that the total annual profit of the firm was $1.76MM. Of this $1.76MM, $937,500 is revenue recognized but never received in cash, leaving $662,500 in actual cash profits for the owners or reinvestment each year. This paper profit of $1.76MM but actual cash availability of only $662,500 induces owners to seek out assistance. An additional $665,000 would be available as profit but cannot be claimed.

Conclusion

Efficient and effective back-office operations can have a significant impact on a firm’s profitability. This is especially true with back-office operations that sit at the nexus of the firm’s business, whether finance, IT for information-intensive industries such as finance, supply-chain for manufacturing, and other critical departments. Firm X needed an operations expert to analyze the operations, isolate the costs and recommend improvements, at a reasonable cost to the business.