For many industries and companies, 2022 was expected to be a time for recovery and renewal. While the war in Ukraine further stresses an already strained economy, few observers currently envision a recession. Nonetheless, as companies pursue today’s market opportunities, Protiviti’s Jim DeLoach explains how they must also evaluate their contingency plans for dealing with varying degrees of potential economic downturn.
It’s The Economy, Stupid
A fall 2021 global survey conducted by Protiviti and NC State University’s enterprise-wide risk management initiative found that the economy ranks as a top-five risk over the next 12 months and the next 10 years. So, for the 1,453 participating directors, CEOs and other C-suite executives, economic headwinds present a long-term concern. Likely sources of recessionary risk — many of them interrelated — include:
- Uncertainty over central bank monetary and interest rate policies, driven by gargantuan central bank balance sheets
- Ballooning government deficits and the specter of lasting structural inflation
- Further inflationary pressures fueled by tightening labor markets and rising energy costs
- Unknowns associated with nations’ struggles to transition from fossil fuels to renewables
- Supply chain uncertainty: How long will it take for congested supply chains to recover; for companies to de-risk their sources of supply then meet recovering market demand?
- Growing geopolitical tensions — the war in Ukraine — and the potential for regional conflicts and their economic ripple effects
- Performance of the Chinese and other large markets
- A lingering pandemic and the risks of future pandemics
Hope for the Best; Plan for the Worst
The point is that no one can say with certainty where the economy is going. The forces of globalization create an interconnected web of dependencies such that one or two dramatic events could set economic activity into a tailspin. There is the adage that there is no better time to prepare for an economic downturn than when the economy is healthy.
No doubt memories of the 2007-08 Great Recession have faded. For this and related reasons, it becomes a good idea to review the organization’s contingency plan so that management is prepared to act decisively on an established game plan if recessionary times are triggered by one or more sudden events.
Entering a distressed environment without a credible contingency plan that has been carefully vetted by executive management and the board can lead to knee-jerk reactions and serious errors in judgment that will reflect poorly on the quality of the organization’s leaders. I wrote on this very topic 19 months before the pandemic hit. But today, as dynamics have changed, I have penned a refresh. Below are 12 suggestions across four areas to consider when formulating a plan to stabilize and preserve the enterprise during an economic downturn:
- 1. Evaluate headcount and hiring: In a distressed environment, management must focus on retaining the company’s “A” players. Objectively determined workforce reductions and changes to hiring practices (e.g., a hiring freeze) are imperatives. In today’s digital economy, a downturn may present an opportunity to eliminate jobs that can be displaced by technology with the attendant workforce reskilling and upskilling.
- 2. Adjust compensation, benefit and incentive plans: Temporary revisions to these plans may be necessary to sustain financial health and stabilize operating margins. To engender support for implementing the plan, it helps to explain to key personnel the economic realities of a declining top line and the need for adjustments in the cool of the day before the distress begins.
- 3. Cut back on selling, general and administrative (SG&A): While there is no one-size-fits-all approach, there are many opportunities to increase efficiencies and reduce these costs. During the pandemic, such cuts were commonplace as technology-enabled virtual environments replaced or reduced in-person meetings.
- 4. Manage counterparty and strategic partner risk: Credit risk increases during a downturn, requiring management to carefully monitor credit policy, customer relationships and past-due accounts. Suppliers may face distress as well, necessitating attention on that front to address the risk of one or more significant suppliers ceasing operations. For struggling suppliers, management may want to consider the company’s options to enable a quick pivot if this were to happen.
- 5. Review other options: It may also be tempting to stabilize margins over a given period through hedging raw material prices and locking in sales prices. Management may also consider outsourcing noncore activities that are not strategic to the business, e.g., certain HR support, accounting, manufacturing and transportation activities.
Balance Sheet Management
- 6. Evaluate asset divestitures: Company assets should be categorized – underperforming versus high performing, strategic versus nonstrategic — and a plan developed for each asset category. Diverse, capital-intensive companies with underperforming assets or divisions can sell them to minimize or avoid losses, reduce debt and generate liquidity and working capital. High-performing, nonstrategic assets can also be sold to raise capital. The timing and immediate/long-term financial impact of asset sales should be considered along with the impact of restrictive debt covenants. Timing is a critical factor, as valuations diminish once the market is depressed.
- 7. Focus on liquidity: Reduced cost structures and improved balance sheet health increase capacity to weather the storm. Cash is king. Monitoring and maximizing cash flow is a powerful differentiator in how a company emerges from recession relative to its competitors. Inventory levels should be monitored closely. McKinsey found that while revenue profiles of both resilient and non-resilient companies are not much different during a recession, the former report margin improvements whereas margins decline for the latter. Proactive cost cutting and a strong focus on leverage lead resilient companies into a superior liquidity position and support investments for a springboard recovery once the downturn ends.
- 8. Develop a hierarchy for cost-savings initiatives: The plan should offer a menu of cost-saving initiatives that could be implemented in the event of a downturn, with targeted cost savings in the current and subsequent projection year(s). Each initiative should be prioritized to create a scalable plan. Depending on the severity of the downturn, some or all the initiatives can be implemented. Initiatives might include reductions in headcount, marketing spend, expansion initiatives, consulting fees, bonus and benefit programs, travel costs, community support, charitable giving and auto allowances. They also might include discontinuing underperforming operations.
- 9. Preserve relationships: Tough times call for focused efforts to sustain customer loyalty. Major customers require personal attention, more frequent communications and — most important — empathy. Account executives should be tasked with the responsibility to formulate personalized plans considering each customer’s financial health and specific needs. Strategic supplier relationships are important, too. Procurement may need to function differently as key suppliers deal with the effects of the downturn. Straight talk and forging mutuality of interests in the relationship with an eye toward regaining normalcy during the recovery may work best in achieving the “win-win” that will sustain the relationship. Working closely with customers and suppliers during challenging times establishes trust and gives the company an edge in sustaining valued relationships during the recovery.
- 10. Communicate with the workforce: In times of economic uncertainty, employees like to know where they stand as they and the organization navigate the downturn. Straight talk and transparent communications preserve morale in tough times, as no news does not necessarily mean good news.
- 11. Sustain strategic investments: It is important to sustain key on-strategy investments during the downturn to preserve market image and branding and foster a strong recovery when the economy bounces back. Viewing market-facing expenditures as a pure cost can lead to deep cuts that undermine the strategy. It may make more sense to focus marketing on sustaining brand awareness during the recession. Investments in new technologies and research and development may also be necessary to drive innovation and sustain competitive position, particularly if there is exposure to digital disruption.
- 12. Turn the lights back on: Postponing planned and discretionary investments in the face of significant uncertainty is an oft-used management prerogative, especially when the dark clouds of a downturn threaten. But as the recession nears its end, management needs to quickly ratchet investments back up as waiting too long can weaken the recovery.
The above are a start. But to be truly effective, a contingency plan should sequence, prioritize and group actionable steps by function and operating units to establish clear ownership, authorities and accountabilities. It should determine key metrics to be managed against specified targets. Such metrics may include net operating income percentage, gross margin percentage, acceptable variance from budget, earnings per share, minimum cash balance and maximum debt level.
With targets identified, a financial forecast over an appropriate interval should be developed to establish a baseline. Different scenarios — revenue declines of, say, 10 percent and 20 percent — should be selected for applying the costs and expected benefits from the above suggestions to determine specific actions management and the board should take. This way, a playbook is created for each scenario.
Once the plan is completed, it should be reviewed and approved by the board of directors. Moreover, management should review the plan periodically — say, annually — to ensure it remains current, briefing the board following such reviews. When it is necessary to put the plan in play, its implementation should be supported by a project management office (PMO). The PMO can then monitor achievement of the assigned initiatives and provide status reports to executive management and the board.
Act Now: Develop Your Plan — Before Crisis Hits
Regardless of expectations for the economy over the next 12 to 24 months, it is both practical and prudent for executive management and directors to insist on developing a response plan to deal with a severe economic recession. Do this now, in the cool of the day. Because when crisis hits, time is of the essence. Formulating a contingency plan is simply a smart play. It equips the chief executive with a stronger narrative to share with the street and enables the board to demonstrate due care in discharging its oversight responsibilities to address a credible threat. The resulting decisiveness under fire will convey competence and rational business judgment to the company’s stakeholders.