This is the third in a multi-part series on the “End of Globalization” and its impact on the middle market.
The next few years will not be business as usual for any middle market firm. Too much is happening too quickly to leave any firms untouched. Most troubling about the coming environment is that we have little understanding of how the known agents of change will play out over time. And with many factors changing at once, we don’t yet know how the combination will impact our business environment.
As we enter an era of unpredictable disruption, business leaders need to assess how this will impact them and what changes they need to champion. And these changes are even more critical for middle market leaders because there is less room for error with small companies. A few strategic missteps, and you are out of business.
When I was going through Army Airborne training, the first man in the jump stood in the plane’s open door with his “knees in the breeze,” waiting for the green light that signaled it was time to jump.
Middle market firms are like that—hyper-exposed to market change. They always have their knees in the breeze. So successfully navigating disruption is essential to stay in business.
Leadership stakes are high for smaller companies because most do not have the balance sheet or market diversification to survive a significant strategic or competitive misstep, unlike large firms where equity or diversification masks poor decisions. An example we experienced with one client this year was an inability to “get ahead of” rapidly rising input costs. The CEO believed his clients would never accept price increases, so he continued to price based on historical average costs—eliminating most of their profit.
Fortunately, the family office that owned the business understood the need for rapid pricing actions, and we were able to establish pricing that reflected market conditions. Their clients accepted, and we added several million dollars to EBITDA.
Strong leadership is also critical because most firms lack documented processes. This lack of “professionalization” means critical business areas rely on individual knowledge developed over the years, passed down through hands-on learning, which is siloed in individuals and departments. The challenge arises when disruption impacts multiple departments and new ways of doing business are required from multiple “experts” within the company. A recent client had never developed a stage-gate process to identify the criteria for accepting new products and clients. Relying on (outdated) tribal knowledge, they were unwittingly filling their pipeline with difficult to manufacture and unprofitable opportunities. Although the environment had changed, their ingrained knowledge had not. But in an environment where input costs were increasing by double digits every quarter, our mandate was not if but when to install these new processes.
When times are tough, it is lonely leading a small company. Most firms have only a handful of leaders (and often one or two) with the capacity to assess and drive rapid change. When disruption occurs in the middle market, responsibility for change is usually vested in executives already working more hours than they care to admit. And when business gets disrupted on many fronts, the ability to make sound decisions erodes and leaders become overwhelmed. They may decide the best option is to solve it themselves or to just maintain a business-as-usual posture. We see this with clients who have unsuccessfully tried for months (and often years) to solve difficult issues. When they finally engage outside assistance, they have wasted millions of dollars and often have lost top talent whose faith in the company evaporated when they observed their leaders taking no action.
Our mantra is that it is a full-time job to run a business and a full-time job to change it. The leader who assigns both jobs to a single individual (or themselves) should not be surprised by the resulting poor performance on both fronts.
I spent a few years as an intelligence officer working with mechanized infantry units in the Army. My role was to stay informed about the enemy and the environment and share that knowledge with everyone in the Brigade. We never assumed that the environment or the enemy would be 100% predictable, but we knew that forewarned was forearmed, and our tactics were always changing based on the enemy and the environment. That mindset is essential for business leaders today. Changes are in motion across the business environment and they will impact every middle market business. Leaders need to understand how their environment and competitors react and change, and then adapt to survive.
The New Cold War: As we mentioned in our first article on The End of Globalization, the world is entering a new Cold War era where global trade will change and barriers we have not seen since the ’80s will re-appear. Trade between the US and Russia is essentially over, and NATO has largely locked arms with sanctions against Russia. Many believe that as long as Russia has troops in Ukraine, these sanctions will remain. With the evidence of war crimes around Kyiv, Putin will never again be accepted as a leader on the world stage, but if he remains in power, the Cold War barriers to trade will increase. And if regime change happens in Russia, it is certain to be another disruptive process. We have already seen prices skyrocket in the energy and minerals markets, and for our clients in the food industry, grain prices have increased overnight by over 50%. Mass starvation is predicted in some countries that rely on Russia and Ukraine for grain imports. In the US, Biden has reinstated some drilling on Federal lands, which was unthinkable prior to the invasion of Ukraine. And remember, this war is only now in month two.
The China Lockdown and Alliance with Russia: Although Russia has a relatively small economy, China is the world’s second largest economy and today over 400MM Chinese across 45 cities are under full or partial lockdown. Shanghai is entering the third week of a total lockdown, and the port of Shanghai (which handles 20% of Chinese traffic) is essentially closed for business. And because President Xi will petition for a third term this fall, the Zero Covid policy that is behind these lockdowns is not likely to be relaxed. With the world’s supply chain only beginning to recover from prior COVID lockdowns, this is not good news.
China has also sat on the sidelines of the Ukraine conflict, failed to criticize Russia, and their government-controlled press is suggesting that US actions are a cause of the conflict. In a recent speech, Treasury Secretary Janet Yellen said the US is closely watching the actions of China and Russia and “Going forward, it will be increasingly difficult to separate economic issues from broader considerations of national interest, including national security.” And there are other large countries, notably India, who have failed to criticize Russia for the invasion, due in part because India buys the majority of their weapon systems from Russia. Even Switzerland, noted for their historic neutrality, has joined the international community in sanctioning Russia. Sitting on the sidelines in this conflict will not be viewed as a positive sign for future trade with the US or Europe.
We have had a decade plus of global sourcing availability, relatively predictable shipping costs, and energy and commodity prices that traded within a manageable range.
Middle market leaders should plan for a future with much greater cost volatility.
The US Economy: Looking closer to home, we have experienced our own sea changes. 2022 marked the end of government-sponsored programs that provided critical assistance for tens of thousands of small businesses (PPP and Employee Credits) and also ushered in inflation above 8% (a 40-year high). This has changed the lending landscape. Banks have begun tightening underwriting requirements, and the Fed is discussing multiple 50 basis point rate increases for the remainder of 2022. They are also scrutinizing their credits more carefully because they know that some clients will not succeed in navigating market changes.
The era of (nearly) free money and easy business credit is coming to an end while the costs of doing business are rapidly rising. Energy, logistics, input costs, wages, and manufactured goods are all seeing double digit and greater increases, and these increases are impacting every business in the US economy. One of my colleagues who runs a large manufacturing company in the Midwest raised starting salaries for unskilled labor from $15 to $27 an hour—and still has hundreds of open positions. Entry level workers are not available in the numbers he needs, at any price. The solution is to bite the bullet and automate, but equipment suppliers he has approached have orders backed up for months. This is the new reality.
And let’s not discount the impact of digitization. The combination of technologies today that are moving with breakneck speed add to the market disruption. Today, most clients automatically search the internet for information, availability, comparison pricing, and user feedback. And responding to customers through their chosen media means that every company needs a digital strategy. Leaders who see information technology primarily as transactional support are literally living in the past—and in danger of being displaced by a new breed of competitor.
Although much of the technology, like AI, is “invisible,” huge advances in visible technologies like robotics will capture almost $125BB of investment in 2020, with a 35+% growth rate for the remainder of the decade. While most of that spend is in discrete manufacturing, followed closely by process manufacturing, resource industries, and healthcare—the message is clear: you need to rethink your digital strategy to serve a new generation of clients.
The Sky is Falling!? For those who would call this “chicken little” thinking, let’s review:
And competitors are using technology to create disruptive options which may be viewed more favorably by your clients. We have entered a perfect storm for business.
How to Weather the Storm
There is no magic bullet. You need to determine how your business will be impacted and identify the changes required to weather the storm. Peter Drucker said “your assumptions about the environment, mission, and your core competencies – must fit reality.” In essence, he was saying that when the reality of the marketplace changes, leadership needs to adapt the business to meet these changes. But too often, middle market leaders don’t think that market changes apply to their business and believe if they just wait it out then business will return to “normal.” Spoiler alert: a dynamic business environment is the new normal for the next several years at a minimum. Waiting it out (AKA doing nothing) is not a survival strategy.
First, establish the leadership mindset that change is required, beginning with critical areas that impact your company as seen through the eyes of your customers.
Rethink your Product or Service offerings to Deliver Outstanding Client Value.
This is an area where disruption can be an advantage. Leaders that view change as opportunity recognize that the most important changes are not happening inside your business. Instead, those changes are taking place with your customers and with prospects you are targeting as future customers. These leaders understand that there are always unmet needs with customers and prospects, and new needs emerge especially in a changing environment. Understanding those needs and changing your products or services to meet them is the winning formula.
Start with a “voice of the customer” survey and hire an outside firm that specializes in client surveys. Although NPS (Net Promoter Score) type questions are helpful, we recommend a deeper level of inquiry to understand: why customers buy from you, your share of customer spend, what they buy from competitors, and the Lifetime Value of different types of clients. Also, design the questions to uncover what we call “the white space” that reveals unmet needs. Every time we have performed these surveys for our clients, the insights have been a revelation and the catalyst for both product and operations changes.
Results from these surveys have no value unless leaders view them as catalysts for change. And the firms that win in coming years will take the best ideas for product and service innovations from customers and prospects. The good news is that true economic value is always derived through innovation, and there has never been a better time to build innovation into your leadership thinking.
Perform a Ground-Up Redesign of Your Supply Chain
The historic strategy of a lowest cost, predictable, global supply base that worked for many years must be re-examined. In most companies, supply chain relationships developed over the years have become “the way we do things.” But in today’s environment, people spend a large portion of their day fighting fires driven by supply constraints, logistics surprises, and service challenges. The solution in this environment is not to do “one off” supplier changes but rather to perform a clean sheet redesign of your entire supply chain. Much like zero base budgeting, establish your assumptions before you begin. What are your cost vs. availability tradeoffs? How will you manage increased logistics expenses? Should you be offshoring, nearshoring, onshoring, or some combination of the three—and do you have alternate suppliers lined up? Can you afford bulk buys and hold safety stock? Then build a “best case” supply chain that assumes you are starting the company from day one. With what you now know, what choices would you make? Of course, there will be compromises, but the clean sheet exercise will open your company’s eyes to options that would not otherwise consider.
One firm that had sourced exclusively from China established a one-person office in Singapore that enabled them to move production to multiple Asian countries and establish dual sourcing for all critical components—including new domestic sources. The team in Asia also met personally with suppliers that allowed them to “jump to the head of the line” for items with long delays. This firm was thinking outside the box on how to redesign a supply chain that can deliver in a less certain environment and is “future proofed.”
Ensure Leadership is Involved in SIOP or other End-to-End Planning
In any dynamic environment, it is essential for leadership to involve themselves in the planning and execution of the entire enterprise. The environment is dynamic and unpredictable, and it takes the person at the top, who sees and controls the Big Picture, to lead the organization through this change.
So how does a leader get involved in end-to-end planning? Set up a war room with white boards or other markable media on the walls. Invite your top people to participate in literally drawing out current processes, so you can see the relationships and understand the challenges they are encountering. This provides leaders with the insight they need to prioritize changes. It may involve a complete walkthrough of Sales, Inventory, and Operations Planning in manufacturing and distribution companies, or in service companies all of the processes and operations required to deliver value to customers. And be sure to include supplier and customer feedback in this process. There is no substitute for working through the end-to-end processes to understand what your suppliers, your people, and your customers are experiencing. And what needs to change.
Understand your Cost to Serve and Build Dynamic Pricing Processes
Many companies have been caught off guard in the past year as input costs have outstripped pricing initiatives. And the momentum behind cost increases is accelerating. A company we know in the food manufacturing business learned that the cost of their small plastic containers (which they were not monitoring) had increased 81%. They learned this only after comparing invoice costs. The supplier had not even informed them of the increase. The National Federation of Independent Businesses reports that 72% of business owners raised their prices in the past month, the highest reading in the survey’s 48-year history.
The good news for business leaders is that most customers are no longer fighting price increases, provided they are justified with “defensible costs.” We have clients who have successfully taken multiple increases in the past year with Big Box clients who historically fought them over a single annual increase. Unfortunately, the processes behind understanding your true cost to serve, which is the foundation of defensible costs, do not exist in many middle market companies. We recommend that every business leader install similar tools, and keep them updated quarterly to ensure that you understand where you are making—and losing—money. Doing this may require investments in your data infrastructure and financial leadership but will pay dividends in informed decision making.
Once you understand the quantitative “Cost to Serve,” you can then move to the qualitative elements of pricing. These involve the size of the relationship, whether this client is a “minnow or baby whale,” other opportunities in process with this client, impact on other business relationships, and other qualitative factors. After reviewing all relevant client and market data, we recommend that middle market leaders establish a pricing committee and that final prices be set by this committee and the business leader. Pricing has a direct impact on profits. Every positive pricing action flows directly to the bottom line, and failure to protect margin is equally impactful.
Identify your Action Oriented People, and Task them with Change Leadership
Leading your company through a period of disruption is hard because we are pattern driven organisms and inherently resistant to change. Once we learn a certain way of doing things, we grow comfortable with that pattern. Changes to these patterns are stressful. Even if you are a leader who embraces change easily, it is important to understand that not everyone shares your enthusiasm for change.
Fortunately, there are a wide variety of personality types, and some of them are more comfortable with change. At FortéOne, we use a combination of proven personality analysis and evaluation techniques to understand working styles, which helps us identify leaders for change initiatives and assemble complementary teams. Every business leader needs to understand their key people’s personality profile and work style to ensure they have “the right people in the right seats.” Companies that use HR analytics in hiring may find their turnover reduced, work satisfaction scores increase, and they are able to assemble much more productive internal teams.
However, you may need to reach down in your organization to find the “change savvy” people to lead your new initiatives. Often managers who are excellent at maintaining close control of processes are the wrong people to lead change. This is an opportunity for leaders to test promising talent within the firm. But set them up for success by pulling them off other tasks and allowing them to focus on change leadership.
Have a People Strategy that Reflects the New Reality
Yes, the labor pool in the US and the expectations for work at home options have changed because of COVID and will likely never return to where they were pre-pandemic. But committed and motivated people are the most important assets in all businesses, and leaders must develop a labor strategy that reflects the new reality. This means you need to adapt to the following:
When the Going Gets Tough, Leaders Take the Initiative
In closing, allow me to share a few lessons we have learned over the years:
In the midst of WWII, Winston Churchill said: “Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” We are only now at the end of the beginning in terms of change. Leaders should act accordingly.
Contributor: Mark Rittmanic, CEO
Over the next several weeks, we will continue to discuss other meaningful topics aimed at helping Middle Market business leaders navigate through the seismic shift being caused in their industries and companies by the end of globalization as we know it.
If you’d like to see something specific in this series or would like our take on another topic of interest, please reach out to us today.
Have you missed any of ‘The End of Globalization’ series?
Volume I: What the Invasion of Ukraine Signals to Your Middle Market Business and How to Prepare
Volume II: Information and the Middle Market
At FortéOne, we’ve been on the forefront of change as thought and implementation leaders for more than 20 years. Our mission is to help Family and Privately Held Business owners as well as Private Equity and Family Office investors become performance leaders in their respective industries. We are more than consultants—we are problem solvers who work side-by-side with you to deliver a business transformation that improves performance and accelerates change in your middle market company.