Question

Discuss why you believe the management teams at Sears & JC Penny continued to make poor decisions? What steps should the Board of directors take once it appears a management strategy is failing? How can we, as accounting professionals, assess when a management strategy appears to be working and when it is failing?

Answer 1

By now, institutional and individual investors are completely aware of the stresses that Sears Holding(SHLD) and JC Penney JCP -4.21% are going through. These icons of America—homegrown retailers—are looking like they may never recover the crowns they once wore.

The companies that once were praised by stock analysts are now greeted with headlines like “Which is Worse: JCP or SHLD?,” “The End Might Be Near for JC Penney,” and “Sears Treats Customers Like They’re Total Idiots.”

The popular opinion is that poor management has led to the demise of both companies. For Sears, that would presumably be Eddie Lampert, while Ron Johnson would be credited for running Penney aground. There is much evidence that this indeed could be the case for both companies. One simply needs to google both names and follow the development over the past two or three years. The damning narratives are all there to review, and it’s very hard to deny that both executives may have chosen the wrong strategies to lead these companies.

Quite simply, JC Penney tried to be something it isn’t: a boutique retailer. That’s a little like an astrologist trying to become an astronomer: it’s not only too unrealistic, it’s downright seeking a totally new identity. In this case the astrologist was Johnson, and it appears that he never conducted consumer surveys to validate his retail instincts. Fast forward two years later and Penney’s outcome is very doubtful.

Sears is a little different. While Penney’s now former CEO had substantial retail operating experience, Sears’ CEO is a hedge fund manager with limited retail experience. Prior to Lampert’s taking the title, there had been several other CEO’s appointed and dismissed by him. He is similar to Penney's Johnson in that he tends to make strategic decisions based on intuition rather than referencing marketing research data.

I think it is too simplistic to explain away these two companies’ current state by solely blaming their CEOs. Something more has to be working against their execution plans than just poor management.

List of Steps

1. Write Business, Sales/Marketing, and Operation Plans

Investors, management, the bank, and employees all need to know what the company’s future plans are. They need to see where they fit in, how they can help, and how they can share suggestions based on their expertise that will help the company succeed.

2. Meet With Key Personnel and the Board of Directors

You must get the key people in the business together to have a no-holds-barred discussion on how to fix the company. Don’t go into the meeting without a plan of your own. People lose confidence in leaders who lack a plan and vision for their business. The key in this type of meeting is to be self-assured, open-minded, and flexible.

3. Revise Plans

After listening to key executives in the business and discussing important aspects of your plan, revise the plans again before presenting them to the board of directors and employees.

4. Meet with Employees

Have a company meeting, admit that there are things wrong with the business, and discuss how management plans to fix it. Provide employees with relevant parts of the business plan and ask for their input. For an established firm, this step demonstrates that careful consideration has been given to the development of the business.

5. Meet with Customers

Rumors of your imminent demise are swirling around the business community. Key customers are becoming nervous and some are even looking for new vendors. Don’t stick your head in the sand. Inform your customers about your situation and tell them how you plan to correct it. Be reassuring, but not deceitful.

6. Meet with Vendors

Company vendors get very nervous when they hear “on the street” that one of their customers is having trouble. Sometimes word travels faster than your ability to thoughtfully alert the appropriate people. You need to develop a prepared statement outlining the problems and how you plan to deal with them. You will receive plenty of concerned telephone calls. Respond quickly and thoughtfully to all of them.

7. Contact Tax Authorities

If you can’t pay your local, county, state, and federal taxes, notify the authorities. Tax authorities will usually work with you. You’ll be on much better terms with them than if you fail to pay and have it appear as if you were trying to avoid your obligation.

8. Cut Unnecessary Costs

Make a list of all your expenses and eliminate what you don’t need. You need to buy time in order to fix your problems, and cutting expenses is a good way to buy “financial” time. You might want to create a break even analysis or even a proforma income statement to help you determine the viability of your business.

After looking at hundreds of small businesses and working on a number of them, I have seen certain patterns of conduct recur again and again that lead to eventual failure. If a company is in difficulty, it is almost always a management problem, scarcely ever bad luck.

When a company survives for many years but finally comes upon hard times, it usually means (a) that there is a valuable core of talent and expertise somewhere in the corporate structure yet (b) some persistent management inadequacies have gradually eroded its strengths and left it vulnerable to whatever adverse fortune it encounters.

In a moment, I shall get into those areas that cause management the most trouble, but first permit me to clarify one point. While this article focuses on the lessons I have learned about operating small manufacturing businesses, much of what I discuss is applicable to the practical problems faced by operating units of sizable companies.

In my judgment, there are three principal areas of weakness in small businesses that cause trouble, all of them management centered.

1. Growth of sales is commonly seen as the solution to all problems. There is an unawareness that, except in the short run, there is no such thing as fixed overhead. Managers, trapped by the concept of marginal income accounting, bring out additional products, believing that their overhead will not be affected.

2. Inadequate product-cost analysis blinds managers to the losses incurred by adding new products willy-nilly. Usually, there are one or more products or product lines that should be dropped.

3. Gearing operations to the income statement, while ignoring the balance sheet, is all too common. Lack of concern with cash flow and the productivity of capital employed can be fatal. Managers tend to seek new funds instead of making better use of those they already have.

1. Growth for Growth’s Sake

The most common cause of trouble is the widely held belief that the only road to success is through growth. Many businessmen see growth of sales as the solution to all problems. It seldom is. Growth is not synonymous with capitalistic success. In fact, shrinking the number of products or product lines is usually the surest route to better profit and higher return on investment.

The mania for growth is commonly expressed in the battle to increase sales. Standard methods of accounting tend to encourage the belief that higher profits automatically follow from higher sales. Several standard accounting techniques tend to mislead those who accept standard cost allocations as gospel.

Marginal income accounting

Much has been written about the advantages of marginal income. The theory is that, for a short period, additional sales can be added to the normal sales volume profitably even at prices too low to cover a proportionate share of fixed overhead. Managers often do this because they presume that 100% of the fixed overhead of the company is borne by their regular business anyway.

However, pricing your product so that it does not cover a full share of overhead is dangerous. Except for rare and well-controlled exceptions, marginal business taken to keep the operation going incurs the same overhead costs as the regular business and, by adding to the complexity of the total operation, often requires more than normal overhead.

Recently, one company manager proudly mentioned that his leading accounting firm had advised him to price all products to obtain any profit margin over his direct material and direct labor costs. He had taken this advice to heart. No wonder his company was in trouble.

Yet, if the overhead really cannot be cut during a short period of overcapacity, it may make sense to take added business at prices that will pay less than full overhead expenses. Even a modest contribution to paying these expenses for that period may be better than none. However, the danger is that an emergency measure often becomes standard practice. It is a good way to go broke.

Break-even accounting

Another management tool that inadvertently encourages growth for growth’s sake is break-even accounting. Like marginal income accounting, the theory is that certain elements of overhead cost vary with the volume of operations, while others, which are called “fixed costs,” do not. The sale price is set to provide for material and labor costs, plus variable overhead costs, plus an additional increment to allow for fixed overhead costs and profit. When the sales volume is high enough in a given period to absorb all variable costs as well as the lump of fixed overhead costs, you have reached the break-even point. The margin above variable costs on additional sales goes entirely to profit, because all the fixed overhead costs have already been taken care of.

No wonder a manufacturer gloats about a high-volume month, because, although he makes no money and actually loses until the volume reaches the break-even level, his profit on volume above the break-even point is disproportionately large.

The fallacy of break-even accounting is the assumption that expenses are easily divisible into fixed and variable. Overhead is rarely as fixed as accountants are inclined to think, except for very short periods. In any long-range analysis of a business, there is no such thing as fixed overhead—it is all variable to some degree, even such items as rent, heat, light and power, depreciation and amortization, professional services, and executive salaries. The terms “variable overhead” and “fixed overhead” would be better called “overhead that varies immediately with the level of activity” and “overhead that varies in the long run with the level of activity.”

Except in the very short run, there really are few, if any, fixed expenses. If you lease a 100,000 square-foot plant for a ten-year term, cost accountants will normally treat your rent as a fixed expense. But is it really? If you don’t have enough space, you can rent more and thus increase that expense. If you have too much space, you can sublet part of the space, or if that is impractical, you can even buy your way out of the lease and move to a smaller building. Thus rent expense can go up or down.

The danger is that some managers tend to pay no attention to so-called fixed expenses. Even worse, they assume that they are stuck with them and see an increase in volume as the only means to pay for them.

Variation of break-even costing

Manufacturers often take their profits only at the tail end of a run, absorbing all their fixed overhead before any profit is counted. In airplane manufacture, for instance, it is common to determine how many planes must be sold before the company breaks even. The danger of this variation of breakeven accounting is that it may stimulate concern with volume of sales, not with margins.

As such, once the fixed costs have been absorbed, profits on the last increment of volume (either monthly or, if it is a one-shot product, by unit) are big, thus encouraging the attitude that more is automatically better.

It is understandable that accounting practices permit amortization of much of the special costs of a particular project (largely tooling and start-up costs) over the estimated number of units expected to be produced. Also, management may be wise to plan for low sales to avoid the unpleasant possibility of taking a big write-off on unamortized costs should the product not sell well. The result, however, is to put the major emphasis on marketing effectiveness rather than on cost effectiveness. It is not surprising, therefore, that increasing sales is the generally accepted prescription for all corporate ills.

2. Inadequate Cost Analysis

At best, cost accounting is an inexact study with limited goals. It is a method of looking at the direct costs attributable to a particular product or activity. However, it does a poor job of allocating indirect costs. Old and new product lines are normally charged the same proportionate amounts for overhead, although the more recently added lines cost far more to start up. The new product line that adds one more straw to the management load rarely gets charged as much as it should, while the well-established line that runs itself is expected to carry the load for the new line.

Research and development costs, for instance, are usually charged to current operations which they don’t benefit rather than to the new lines that the R&D is supposed to develop. It is probably necessary to have the old products subsidize the introduction of the new ones. Many managements are scarcely aware, however, that they are doing this. Therefore, they undervalue the profits on the old line and understate the costs in bringing out the new one. The effect is to encourage costly new projects and downgrade current results.