Plan redundancies while turnover still yields normal profit

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Previous employment lessons will help managers plan BrexitAs we head into a period of huge uncertainty, the prospect of managers having to make staff redundant looms. And it’s likely that for those managers, this will be the first time since taking their management role that they’ve had to think this way.

Whilst there’s no recession certain, it is worth managers knowing the issues if a downturn following Brexit ultimately means slimming their organisation down. This blog is not about how to make staff redundant – we’ve enough on our website on this already. It’s about the thinking that needs to be done as the firm’s position weakens and action seems likely. It’s about how to plan to avoid issues.

Our point is that managers should plan redundancies while turnover still yields normal profit.

Brexit and the future

Brexit is upon us. It is likely that the economy will weaken, GDP will fall and unemployment will rise – but when it’ll happen, how low the economy will go and for how long, no-one knows. What is certain is that management confidence is weakened.

The economy relies on everyone spending. When everyone stops spending, because their confidence in the future is down, company turnover drops. Given costs at a level commensurate with a higher turnover, firms then go from profitmaking to lossmaking. The normal option for managers is to cut costs in line with turnover reduction to sustain at least breakeven.

Confidence is all about how people, and specifically managers, feel about the future. For a manager to feel confident, they must believe that, whilst there are problems just now, turnover and profits will soon return. Confident managers borrow and use cash reserves to invest to overcome recession. Managers lacking confidence in the future will cut costs. Clearly managers can start out quite confident and that confidence can be dashed as a downturn takes hold.

Key metrics to inform thinking

There are two key metrics that define how managers might think, and ultimately how they might behave in a period of low overall confidence. The first is productivity. The second is shareholders’ funds.

Productivity is the output achieved from the firm’s systems for given effort and resources. In simple terms it might be a measure of the turnover per person – the turnover divided by the total number of people on payroll. In a recession, the productivity can remain constant – the turnover reduces and the headcount is reduced correspondingly. Alternatively, managers can aim to improve productivity over the recession period by investing in technology and in higher staff skills. Higher staff skills might be achieved by investing in training for those key staff that remain.

This shows that if redundancies are used to counteract the effect of a recession, policy should dictate that in any role in which there is to be redundancies, poorer skill staff should go and higher skill staff should be retained and developed further. This gives a clue about the sort of redundancy criteria that should be used to select who goes and who stays.

Shareholders’ funds are the total monies in the business if all liabilities are paid and all debts recovered. In effect it’s the money available to shareholders to either leave in the business as working capital, invest or take as dividend. Shareholders’ funds as a function of time for various different profitability scenarios are shown in the graph below.

One of the key liabilities that is generally overlooked is the cost or redundancies – the contractual obligation a firm has to pay its staff in the event of their dismissal. The cost of redundancy comprises several parts. Statute demands that a person is paid redundancy pay dependent on age and dependent on the number of full years of service to a maximum of 20 weeks. Often professional staff will be due more than the statutory minimum and this will be set out in their employment contract. Those contracts will also set out the period of notice to be given by the firm. Often professional staff will have 3, 6 or even 12 months’ notice. And finally there are the holiday pay, bonuses and other benefits that might be due.

This means that for someone aged 22-41, paid £50k, with ten years’ service and on six months’ notice, the cost of redundancy could run to say £40k just for one person.

Dynamic model

Plan redundancies while turnover still yields normal profitIn the first instance, redundancy costs add to the costs or overheads of the business. They therefore hit profits for the month in which the payment is made, and hit profit for the year. As such they could drive the firm into making a loss. Secondly, redundancy costs reduce the cash in the business and reduce the strength of the balance sheet. As such they reduce shareholders’ funds.

So the issue for managers is at what point the cost of redundancies threatens survival of the firm. Conversely, the issue is at what point to make staff redundant to ensure that survival.

In running a firm and in surviving the 2001 and 2008 recessions, I always had one rule – I would never run the firm with shareholders’ funds below a level that would allow me to pay all staff their contractual redundancy and notice period. Staff should always have primacy when it comes to being paid off from an ailing company.

I my case, my 25-man firm was particularly vulnerable to changes in the technology markets and I took a particularly pessimistic view. Other managers may be less pessimistic, factoring the total redundancy obligation to reflect the probability of continued loss-making.

In whatever form it’s used, this rule means that managers must have high working capital. Not all firms can do this and many use bank borrowing against assets to fund day to day activities. This latter operating model can become challenging when making staff redundant in a period when assets are down-valued and banks become reluctant to lend.

This rule then gives a model for managers to think about how to react in a recession.

The essence of this model is this. As profits reduce, in turn reducing shareholders’ funds, the manager needs to think about the various trigger points. If profits drop but don’t threaten the ability to make staff redundant, and recovery comes, all is well (the upper of the two curves above). If the manager adopts the rule that there will always be enough in the pot to make all staff redundant, and profits plummet and are not forecast to rise, there is a point where the rule will be breached. Action is therefore needed to anticipate the operating position in Year 2 onwards (the lower of the two curves above).

Do it in Year 1

Plan redundancies while turnover still yields normal profitThe aim governing redundancy is to do it once and once only – if at all possible.

In having a round of redundancy in Year 1, in anticipation of a weakened position, two things happen. First the shareholders’ funds drop as they are hit by reduced profits for that period. But second, the liability for redundancy costs from then on also reduces. If the turnover remains the same and the costs rise, the shareholders’ funds and liability drop together and there’s no overall change in the position. If however, there are profits to offset the redundancy costs, the risk of breaching the rule is reduced and the overall position is improved.

Plan redundancies while turnover still yields normal profit

This shows the importance of planning ahead. Redundancies must be planned for when the turnover is still high enough to yield normal profit.

Following redundancy, profits must be recovered and this comes from ensuring that the right heads are shed. Productivity must also rise through in investment in those who remain. The firm then adjusts to being able to do more with less.

The result is positive. The firm has weathered the recession and come out of it stronger. But of course, this will only happen if management plan for it. It’s too late to start thinking about redundancies when redundancies are in train.

This blog has deliberately simplified a complex scenario. Ideally, managers should model the complete time period and run the model for various events. If you’d like help in building a model to consider when you might use redundancies or if you’d like to discuss your firm’s future and when you might consider redundancies as a tool, do get in touch.

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