Dr. John Psarouthakis is a Distinguished Visiting Fellow-Professor, Institute of Advanced Studies in the Humanities, University of Edinburgh, Scotland. Founder and former CEO, JPIndusries,Inc., a Fortune 500 industrial corporation. He is the Executive Editor of www.BusinessThinker.com
FINANCIAL VIABILITY AND THE DYNAMIC SYSTEM MODEL OF MANAGEMENT
(see also, in this journal, articles: Dynamic Management of Growing Firms-Parts 1 through 4)
Profit is a yardstick of how well the entire system functions. When the system runs efficiently, money, time, and other resources are left over; the firm makes a profit. Some firms watch the short-term costs so closely that long term opportunities are overlooked. On the other hand, several consecutive quarters of the operating loss caused by recent heavy investment will test survivability. Profit is what the firm has available to it to combat entropy and the general uncertainty of the environment.
Further, profitability is one powerfully important way to judge the efficiency of different solutions chosen to resolve the seven organization issues of the DSP model. If coordination can be handled through direct observation by the owner, why waste money on elaborate controls and time consuming meetings with managers? If design of the machine can be done in someone’s basement, why build a laboratory? The CEO’s challenge is to find the solution suitable to the needs of the firm at a given size and complexity.
As with profitability, cash flow is heavily influenced by the way in which each of the seven organization issues are managed. Take resource allocation: If too much working capita is tied up in inventory, precious funds may not be available for critical opportunities and emergencies. Poor response to other issues can also hurt cash flow. If sales suffer from poor marketing or product selection (a market strategy issue), cash flow suffers. If sales are strong, but overstaffing is required because of inefficient coordination, cash will be unnecessarily depleted. Poor motivation will have similar results. Just as with profits, efficient responses to every issue will augment overall cash flow. Poor response will diminish it.
Let’s summarize key linkages between financial viability and the other organizational issues to reinforce their importance. The results are based on two or more years of profits unless otherwise noted. In this section we also say a little about how effectiveness of the other seven DSP issues are measured.
Market Strategy and Financial Viability
We measured five components of market strategy effectiveness: (1) The CEO’s rating of direction-setting effectiveness; (2) relative size compared to competition; (3) steadiness of sales growth; (4) rate of sales growth; and (5) total revenues. Notice that size is examined both in absolute dollar terms and in terms relative to the industry.
Market share–not absolute size in dollars–is linked to profitability. Firms that are larger, relative to others in the same industry tend to be more profitable. This is true despite the fact that absolute size of the firm as measured in total revenues is not positively linked to profitability at all. This suggests that it is market share, not size per se, that predicts profits.
Steady growth is linked to profitability. Firms which generate steady growth have a higher two-year ROS average than those with peaks and valleys. Steady growth also contributes in the longer term to a better cash position in the firm.
Faster growing firms are generally more profitable. The rate of sales growth, though sometimes a profit handicap, generally predicts ROS.
CEOs of profitable firms tend to like the way they set company direction. Finally, CEOs who rate their direction-setting strategy as effective are more likely to report higher ROS and a better cash position.
Chapter 6 explores some of the strategies CEOs use to achieve a higher and steadier rate of growth.
Work Flow and Financial Viability
Work flow is made up of two components: (1) division of tasks and authority; and (2) coordination–assuring that everyone’s efforts and overall information fit together in a timely way and efficiently.
CEOs who are satisfied with their work flow strategies likely make a profit too. CEOs who rate the strategy for assigning work as more effective are likely to have higher ROS. Ratings of coordination effectiveness are also connected to profitability and better cash flow. Effective work flow is one of the most important predictors of ROS for small and medium sized firms.
Resource Acquisition and Financial Viability
Within the resource acquisition issue, we look at all types of resources: capital, information, equipment and supplies, subcontractors, managers, and nonmanagement employees.
Only ability to acquire capital is linked to profits. The ability to obtain the resources is surprisingly weakly linked to profitability. Only the ability to obtain capital is linked to profitability, and only during the same year. Not surprisingly, ability to obtain capital is linked to the firm’s cash position in the same and succeeding years. Resource acquisition is strongly linked with other aspects of organization effectiveness however besides profits.
Human Relations and Financial Viability
Though they overlap somewhat, we look at five components of human relations effectiveness: (1) morale: overall job satisfaction and commitment of employees; 2) goal integration: consistency of organization and individual goals; (3) a consistent view of the mission by CEO and managers; (4) a consistent view of values; and 5) how effectively values are shared.
Morale and profits are linked. Consistent with a
decades-old but controversial hypothesis, we find a clear link between morale and profits.6 The firm’s cash position is also reported to be better in the same year but does not seem to be influenced in following years by the level of morale whereas profitability is also higher in subsequent years.
Companies with strong corporate cultures are more profitable. CEOs and managers were queried about values emphasized within the firm. In strong corporate cultures, where CEO and managers report the same values, the firm is more profitable. Similarly, where CEOs and managers share a similar understanding about the firm’s mission and direction, ROS is higher–though here we find a “lagged” effect, an influence delayed by six months or a year.
CEOs who can communicate their values head more profitable firms. Finally, CEOs who rate the way in which they communicate their values as effective also tend to run more profitable firms.
Resource Allocation and Financial Viability
We look at resource allocation from a few different angles: how well people and material are allocated across departments; the quality of budget information (how quickly and accurately you get it); and the effectiveness of the allocation strategy (how well it is working).
Certain aspects of resource allocation are strongly linked to profits, though less so with our measure of cash flow.
Effective resource allocation strategy is linked to profit. CEOs who rate their resource allocation strategy as effective also report higher ROS. The better able the firm is to assign people to the right departments in the right numbers, according to its managers, the more profitable the firm is likely to be.
Managers (other than the CEO) were also asked to rate the firm’s ability to assign equipment, dollars, and material so that all work groups have sufficient resources to operate. Though not related to profits, these were positively linked to cash flow.
Public Relations and Financial Viability
Effective public relations and profits are linked. Our focus on public relations was fairly limited in the research study: We asked CEOs and managers to rate their company’s reputation and image in the community. This rating is linked to both ROS and cash flow.
Technical Mastery and Financial Viability
Technical mastery and profits are linked. We identify four components of technical mastery: technical performance of employees; technical skills of employees; productivity–the firm’s ability to meet schedules and fill customer orders on time; and quality of the services and/or products the firm provides. All four aspects link to ROS and cash flow.
Financial viability is the key to company success. Few firms survive long without sufficient profits and cash flow. This chapter reviews different ways to measure profits. It also provides a quick overview of the linkages between financial viability and the other seven issues of the Dynamic System Planning Model. In the remaining chapters of Part II, we pay individual attention to each of these seven issues, in turn.
1 Cecil J. Bond, Hands-on Financial Controls for Your Small Business (Blue Ridge Summit, PA: Liberty Hall Press, 1991).
2 James L. Price and Charles W. Mueller, Handbook of Organizational Measurement (Marshfield, MA: Pitman Publishing, 1986), pp. 128-30.
3 Robert D. Buzzell and Bradley T. Gale, The PIMS PRinciples: Linking Strategy to Performance (New York: The Free Press, 1987), pp. 135-62.
4 Bryan E. Milling, Cash Flow Problem Solver: Procedures and Rationale for the Independent Businessman (Radnor, PA: Chilton Book Company, 1981) and Bond, Hands-on Financial Controls for your Small Business, are two excellent sources that are written in plain language.
5 Buzzell and Gale, The PIMS Principles, discuss pros and cons of ROS and ROI at length, preferring ROI since it “relates results to the resources used in achieving them” (p.25).
6 Rensis Likert, New Patterns of Management (New York: McGraw-Hill, 1961).