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Shigeo Sunahara
Management and International consultant
Tokyo Japan

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Problem with a Rapid Growth in Business

It is necessary to notice that increasing production capacity is associated with increasing cost associated with production and increasing amount of payment of debt. Accordingly, the capital adequacy ratio decreases to deteriorate the cash flow.
Written Nov 11, 2010, read 5859 times since then.
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A long-established company in the bedclothes industry applied for court protection in Japan. This company achieved a rapid growth thanks to its strategy to introduce high-end bedclothes bearing the names of famous fashion designers into the market, that is, it successfully imported fashionability to the bedclothes business. The story of this company from the beginning of the rapid growth to the bankruptcy tells you about the high risk of high-cost structure common to the brand business besides disclosing the inability of this company to foresee the change of consumer behavior and the dynamism of distribution channels. If a company pursues economies of scale incessantly to achieve a rapid growth without improving the high-cost structure, it will face a big problem soon or later. 

Economy does not seem to recover immediately in industrialized countries. In this condition, many companies hastily try to reduce production cost by means of economies of scale to satisfy consumers’ demand for low commodity prices. Capital investment to increase production capacity is vital to economies of scale. Expanding production capacity in a short period of time usually means a big increase of debt payable. Increased debt payable increases interest payment, and naturally, decreases capital adequacy ratio. Because unlisted medium-sized companies cannot procure capital in the market, they have only two ways to procure capital. Management executives increase the capital by themselves, and the company saves net profit after tax. Knowing the risk of increasing interest payment, most companies are enchanted by a rapid sales increase without improving the high-cost structure. And they diversify their business to get quick returns and increase the number of distribution channels. 

In short, rapid sales increase by means of economies of scale alone decreases the capital adequacy ratio. If you build a new plant, expand facilities, and install new equipment, you have to come up with increasing expenses associated with the increasing production capacity and increasing stocks not to mention increasing labor cost. That is, repayment of principal and interest grows bigger and capital adequacy ratio decreases. In these conditions, a company has cash-flow problems and a high probability of bankruptcy due to a sudden change of business environment even though its results are in black. This situation is symbolized by a medium-sized company that achieves a rapid growth, builds a fabulous company building, increases production capacity, employs a large number of new workers, and suddenly faces financial difficulties because of a sudden business slowdown. 

If a company faces this situation, it had better be realistic and avoid business beyond its capability, namely abandon the idea of expanding the business and take only highly profitable orders, and reduce the amount to settle by draft. Reducing settlement by draft improves cash management and increases the capital adequacy ratio. Generally speaking, if a company increases the capital adequacy ratio to above 30%, it can settle purchases only in cash. As the same time, it is necessary to abandon very small customers by following the four principles. They are not to sell on credit, not to give discount, not to deliver an order, and not to pay a visit for sales activities. Always, you have to keep in mind the risk associated with a rapid business expansion.

Learn more about the author, Shigeo Sunahara.

Comment on this article

  • IT Consulting, IT Support 
Seattle, Washington 
James Murray
    Posted by James Murray, Seattle, Washington | Dec 03, 2010

    Shigeo,

    I think I'm understanding what you are saying. The problem with rapid business expansion is the assumption of unlimited demand. The dilema of the modern 20th century is that we now know that our supply solutions are so effective that they can easily surpass demand.

    In the 18 and early 19th century hand artisans could not exceed demand. Factory automation in the early 20 century taught us that it was now possible to exceed demand. The concept of market share became a new 20th century reality.

    With the advent of computers it is possible to look at customers in a new way. As you mention, when the economy slackens, focus on the most profitable customers. Don't be afraid to let go of the weak customers. The problem is how to predict who will be the best customers two years from now?

    Pareto's rule tells us that 80% of proffits are driven by 20% of customers. If this is true, if we can identify those 20% we can follow through on this idea you've presented of letting go of all but our best customers.

    It seems counter intuitive that letting go of 80% of our customers could actually help the business. Wouldn't that mean losing 80% of business? The reality though is that we only lose 20% of business, but reduce our infrastructure expenses by almost 80%.

    Do the numbers and ROI goes up by a factor of 7. Imagine life working with only your best and happiest customer. instead of expanding the factory or building a second factory, reducing the least productive customers is the key to building a stable business that functions in any economic situation.

    Until the computer, it was impossible to accurately identfy the best customers. Now this task is automated and possible.

    So Shigeo I appreciated your article that seems on the surface counter intuitive, but is actually the key to success in a limited market environment.