How to Hide Losses
How to eliminate losses is quite straight forward: increase revenues without increasing commensurately costs, or cut costs without cutting commensurately revenues.
Simple. It takes work but it is quite straight forward.
In this blog, I want to focus on how to HIDE losses. You still have them, but they do not appear on your P &L unless some smart analysts delve into analyzing the markets in addition to the financial statements.
Here is how. Let me give an example.
A company has two divisions. One is in agriculture, growing wheat. The other one is a bread factory.
The bread factory is losing money. The price of bread is fixed by the government and, for political reasons, it is mandated to have low priced bread for the voting population.
The price in the market of class three wheat, which is the kind of wheat you need to make flour used for bread, is high and climbing because there aren’t many farmers who can grow class three wheat. Fixed low price of goods with increasing cost of raw material means losses for the bread factory. No need for rocket science to understand this.
The CFO of the parent company suggested to merge the bread factory with the agricultural division, and have the wheat grown be first and above all for the bread factory. The price of wheat for the bread factory should be at cost and, voila, the bread factory losses are gone.
The loss disappeared on the books but it is there “hiding” in the lower profitability of the wheat producing division. It is a loss of an opportunity and thus does not show on the financial statement books.
Beautiful trick to hide losses.
The truth is that you cannot eliminate losses by manipulating financial statements or transfer prices. You can hide them, all right. A smart entrepreneur looking at the market would suggest spinning off the divisions and have bread stand on its own, and if it cannot justify its existence on its own without subsidies of the wheat division, let it go. The solution is not in the transfer prices manipulation but in getting out of the regulated bread business and go into unregulated baked goods business; make specialty bread, make cakes, or close up the shop.
There is more to this case to be learned from.
Integrating the wheat division with the bread division looks like an improvement in efficiency. Now the wheat is grown for the bread, and there is less haggling between the wheat division and the bread division at what price the wheat should be charged to the bread division. A common director will decide and, in order to cut losses, probably will charge for the wheat at cost.
Nice and efficient. But, what is being lost is effectiveness. The wheat business is in a totally different business than bread. Instead of focusing on the markets, the common director is focusing on the production side, on efficiency, for the two divisions to cooperate better or have less conflicts. He is facing production and turning his back to the market. In the situation where the divisions were separate, each director had to face his own market and fight for a position in it, and pay market rates for the raw material. The CFO is efficiency oriented, not market and effectiveness oriented.
In a declining market, you should pay more attention to efficiency then to effectiveness. The market plays less of a role because it is declining anyway. Integrating the divisions might be the right answer; Efficiency is more important than effectiveness. In a growing market, marketing is more critical then efficiency and the focus should be more on effectiveness then on efficiency; more on revenue generation than on cost-cutting.
Dr. Ichak Kalderon Adizes