For most businesspeople, the term “contingency planning” conjures images of natural disasters such as hurricanes, tornadoes, earthquakes, or floods and man-made crises like riots, fires, or terrorism. The concept of contingency planning is rarely tied in with routine business performance management. That’s because many companies fail to recognize how important it is to describe in advance, in detail, the steps the organization will take in the event that it fails to meet—or, conversely, in the event that it exceeds—its budget and performance plans.
Financial contingencies require rigorous planning and preparation, just as natural disasters do. And in financial contingency planning, the upside is as important as the downside. It may seem counterintuitive to talk about a contingency plan when a business is exceeding expectations. Shouldn’t exceeding pre-established objectives be cause for celebration? The simple answer is no. Every company maintains a capital expenditure plan and a list of desired projects. Most budgets limit how many capital projects can be funded in a given year, in order to reduce risk and manage cash flow. When profits significantly exceed budget, a business will likely find itself sitting on the windfall at period-end, which means it lost out on the increased revenue that capital investment might have generated.
The primary goal of a contingency plan should be to identify key road markers that management can use to recognize very early when corporate performance is beginning to veer off course. For starters, every company must have clear triggers for action, such as failure to reach sales targets or missing a target profit level. But such simple financial metrics cannot be the end of the analysis. A formal contingency plan should help management react judiciously to changes in the external environment, basing their response to performance swings on a well-thought-out series of leading indicators. When a company makes knee-jerk judgments about a budget miss, it may rationalize away the numbers as a temporary hiccup. We’ve seen this happen frequently in our experience investing in and providing expertise to midmarket companies across North America. And since time is the enemy, delayed action can be very costly.
At one manufacturer of metal-based components for light-vehicle engine, transmission, and drive-line applications, management developed a top-10 list of actions that the company would take if a division’s performance came in much above, or much below, plan. Last autumn, the company’s performance was trending ahead of plan, so management invested in several key areas. This positioned the business for a strong head start into fiscal 2014.
One thing to keep in mind when defining a company’s reactions to specific scenarios is that adjusting fixed costs tends to have a bigger long-term impact than does changing variable costs. Savings on the purchase of materials produces immediate results, which may lull companies into thinking that costs are declining. In reality, however, declining materials costs will necessarily coincide with declining sales. Reducing variable costs does not boost the bottom line over time. Good contingency plans focus on changes in fixed costs. If downside contingencies drive cuts in fixed costs, the company will see significant upside benefits once volumes recover. That is precisely what happened to many companies following the global financial crisis: They reduced fixed costs from 2007 to 2009, then earned a disproportionate benefit when sales rebounded in 2010.