Late Night Discussions
Number 9

by Dr. Eliyahu M. Goldratt

"Jonah, do you mind examining the options which are open for a company that finds itself in a market downturn?"

"Be my guest," he gestures with his bulky cigar. "But please, do a systematic analysis. I have very little patience left for off-the-cuff general slogans, like 'offer the market a quality product,' 'improve productivity' or 'reduce your inventories.'"

"Granted," I smile back. After a while, when I realize that all I wanted to say might be viewed by Jonah as one of those 'general slogans,' I inquire "Where do you recommend that we start?"

"Why won't we start by clarifying what we call a market downturn," he says, and releases another big, gray cloud into the already thick air.

I think about it for a minute and then say, "I prefer to define market downturn in terms of a single company; the operating market of a company has shrunk. It might be due to the fact that the market in which the company operates is down - a recession, or it might be due to the fact that new competitive products appeared in its markets, eating into our company's market share. We tend to blame everything on the recession but in light of the mind-boggling changes in technology, I think that the …."

"Agreed," says Jonah. "Now, before we explore the possible successful reaction of a company facing such an unpleasant situation, why won't we first examine the more common case, the case in which a company is not responding immediately with some innovative actions. I think that it is important to fully understand the consequences."

"Aren't the consequences obvious? The company's revenues will go down."

Responding to Jonah's gesture to continue, I add, "Since most companies do not exhibit more than ten percent net profit, even a relatively small market downturn might cause their net profit to take a nose dive."

"Alex, net profit is important but in our case, of a market downturn, I think that we should concentrate more on the cash aspect."

Yes, of course. Cash is a necessary condition for a company. If it has enough cash, cash is of secondary importance, but if it does not have enough cash, nothing else is important at all.

"I see your point," I say aloud. "In a market downturn the major driver is usually not profit but cash. Cash is drained very fast. And considering the amount of cash available for most companies it doesn't take very long and they must react to the revenue drop by reducing their operating expenses. They must lower the company's break-even point."

"Lowering break-even point, reducing operating expenses, those are very neat sterile expressions," Jonah says in a flat voice. "What is the only effective way to accomplish it in reality?"

I ignore his harsh tone. I know, just too well, Jonah's over-sensitivity to using financial terms in a way that obscures the fact that people's livelihoods are represented by them.

"The biggest component of operating expenses is employee-related," I continue. "It's not just salaries, it's fringe benefits and things like telephone bills, travel, etc. No wonder that in a market downturn a company, after a while, will find itself in a situation where it must lay off employees. The alternative is to close the company and lay off everybody."

"Yes," he replies. "That is what the resulting cash pressure forces so many of them to do. Have you noticed that financially, laying off is equivalent to writing off valuable assets? Of course, even though every top manager will openly agree that employees are the company's biggest asset, they never wrote employees as assets on their balance sheet and thus they can spare themselves the pain of mechanically writing them off."

"Strange world," I admit.

"It is even stranger when you consider what happens after that," he says with a bitter smile. "If we accept your definition that a company's market downturn can be caused by the success of competitors, who is most likely to hire those people? The competitors."

"The same is likely to happen when the market downturn was due to a recession," I gloomily add. "Recessions don't last forever, but not all companies come out of a recession and start to rehire at exactly the same date. It is macabre, you know. When a company has succeeded, at last, to emerge from a market downturn, it has to reinvest in new employees, an action that definitely slows down capitalizing on the market increase."

"Yes, it is macabre," Jonah agrees. "If a company is not reacting immediately to a market downturn, then according to what we just deduced, it will probably face the situation where it transferred its most expensive investments to its competitors, for zero return."

"Which bring us back to the opening question," I say with new vigor.

"What are the options open to a company to successfully respond to its market downturn?"

"The first and most effective one," he responds with a straight face, "is to never go, in the first place, into a market downturn."

"Come on Jonah, be realistic," I'm starting to be a little impatient.

"I am realistic, very realistic. Of course, only if we consider what is possible, not what is usually done."

I decide to ignore his comment and go straight back to the issue. Tonight, I don't have the stomach for fancy theories. "Suppose that a company has already found itself in a market downturn," I firmly say. "How can it respond immediately, before its cash is drained?

"In order to make things even clearer," I continue the discussion with myself, "let's suppose that cash is pressing to the extent that we must exclude avenues that require considerable time. In such a case, developing new markets, developing new products, or investing in significantly improving the company's performance will not help the short term. What can a company do immediately?

"It seems that the only thing left to do," I answer my own question, "is to play with the products' sales prices. This is an action a company can do immediately, from one week to another."

"How can this help?" he asks.

"Many markets are quite price-sensitive," I remind him. "Maybe reducing the price will increase the company's revenues?"

"And you are talking about being practical?" he grins at me. "On what are you basing your expectations? On the fact that reducing sales prices, in a price-sensitive market, results in an increase in the quantities sold. Don't you know that the magnitude of the price elasticity is almost always relatively unknown?" When I nod my head in agreement he continues, "This means that the company doesn't know up front if the resulting increase in quantities will be enough to compensate for the price …."

"I admit that it is a gamble, but...."

"Alex, it's not just a gamble, your suggestion resembles Russian roulette with too many bullets in the barrel. What is the situation you are talking about? The company is not in good shape, it is in a market downturn, its cash is draining, and now you are coming with a suggestion that very likely will accelerate the cash drain? Accepting your suggestion is actually gambling on the company's mere existence, not to mention that even if it does work the company is risking a price war in its core …"

"I know some, but that's beside the point." After a short while, I say "Let me summarize. To start with, many companies are not operating in a price-sensitive market. For those that are, many already have prices that give the highest net profit and thus any price reduction will increase the quantities sold but not the net profit generated from the sales. On top of all that, the risk involved in taking such a step prevents most managers from even trying. According to what we just said, in a …"

"Not at all. What on earth gave you this impression?"

I'm staring at him completely puzzled. Then I remember his favorite words: 'check your basic assumptions, there is always a way out.'

"A clue?!" I half request, half demand.

"I already gave you the clue once, when we discussed the Japanese success. It all boils down to the devastating notion of product cost and a uniform product price."

"Yes, you have mentioned that before but, as you see, it didn't help. Jonah, no matter what, we must devote the next discussion to this issue."

"If you like."

This "Late Night Discussion" is Copyright © 1992 Dr. Eliyahu M. Goldratt