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How to Get Ready for Economic Cycles

Many companies put more effort into planning for a power outage than they do preparing for the inevitable cyclical downturn. Here are some points to consider.

The Red Cross recommends you prepare your home and your family for the possible emergencies and disasters that are most likely to occur where you live.  They recommend you prepare a home disaster plan, rehearse it with your family and set up a kit full of first aid, food, water and other supplies you are likely to need during a disaster.  This is sound advice.

Many companies prepare for business disasters using similar and often more comprehensive guidelines.  Business continuity plans are designed to keep the company up and running through disruptions such as power failures, IT system crashes, natural disasters, supply chain problems, etc. 

But do CFOs and other senior executives have a deliberate plan to be prepared for the inevitable downturn in the business cycle?

This is by no means meant to scare you as I have no proprietary insight on when the next downturn will start and how severe it will be, but I do know that following every other economic expansion we have ever had there has been a contraction. 

On average there have been 66 months between economic peaks since World War II and in recent years this has stretched to an average of 106 months. The last peak was in December of 2007 so sometime over the next few years we are likely to hit an economic peak and then a decline so it seems worthwhile to prepare now.

One of the most difficult problems companies face in an economic downturn is over capacity.  As demand slows they find they have more employees and productive equipment than they need.  This leads to layoffs, which are expensive and disruptive to those losing their jobs, and distressed sales of equipment and real estate.  Management, employees and shareholders all suffer.

But if we know a peak is likely over the next few years we can think twice about our growth investments and maybe miss some of the potential upside at the peak in exchange for being more “right sized” before the downturn happens.  Of course many investments are so good it’s better to just do them but the more marginal investments that won’t hold up in a recession should be avoided for now.

One way to accomplish this is to think differently about fixed and variable costs as we approach the downturn. Although most companies strive to reduce their average cost run rate by making investments that automate processes, they are in effect replacing a high variable cost with a lower fixed cost.  But in a downturn, fixed costs can cause average costs to rise while variable costs can be shed often quite easily.

Another strategy is to embed cancellation and deferral options in contracts for large new capital investments.  In this way, management retains the option of reducing cash outflows which can prove very valuable in a downturn.  Sometimes there is a tradeoff on the price of the capital equipment to get such an option but it can prove to be a very valuable option to have.

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