How to Grow a Company into Bankruptcy! (Part 1)
08 Oct 2019
Cary Selby, CPA, CA - Managing Partner
Many years ago, our firm was asked to take over as accountants for a profitable distribution business. The business had been run successfully for well over 25 years. As the founder moved towards retirement, he brought his son (Junior) into the business to eventually succeed him as President and CEO. The business continued to thrive, with growth averaging about 5% per year.
The founder suddenly passed away, leaving Junior with full responsibility for the business. Junior had been working in sales, and had often clashed with his father over the slow but steady growth. He wanted to see the business grow at 20% per annum.
After the father's passing, Junior planned to achieve this growth. Against our advice, he significantly cut the selling prices of many products in order to steal market share from competitors. In this regard, he was successful as sales increased by about 20% in the first year, and 25% in the following year. However, what he hadn't thought of was the impact on gross profit.
Despite the increased sales, the product costs remained roughly the same. So what had originally been a healthy gross profit margin, had now been eroded to the point where the actual gross profit, in absolute dollars, was roughly the same as before the increased sales.
To make matters worse, the increase in sales resulted in significant increases in overhead expenses as this required more salespeople and thereby commissions. Further, the increased volume necessitated more warehouse and office space. Administrative salaries increased as people were hired to handle the additional workload. Therefore, the initial healthy profit became a small loss in the first year, and a much larger loss in the second year.
Thereafter, Junior realized the mistake he had made. In order to correct this, he implemented price increases to bring the prices back to their previous level. However, in the meantime, his competitors had already made modest price reductions!
Accordingly, the new price-sensitive customers he had attracted with lower prices quickly jumped to his competitors. Additionally, his long-time customers felt betrayed and many moved their business elsewhere.
By the end of the third year, what had been a very successful and once profitable business went bankrupt.
Before you launch a major effort to grow your company, make sure you understand the economics of your business and that you have had the advice of a team of experts.
Stay tuned, as we will discuss the lessons learned from this experience on "How to Grow a Company into Bankruptcy (Part 2)".