How does a recession affect businesses and their value chain and supply chain?
In the UK, the cost of keeping the economy afloat and helping businesses and individuals to survive during the Covid-19 pandemic was always likely to cause some economic turmoil.
Increasing taxes, coupled with the rising rate of inflation, has seen indiscriminate hardship for businesses and individuals alike.
It is important to understand what a recession is, what the value chain is, and what the supply chain is, before looking at how a recession can affect a value chain and a business’ supply chain.
What is a recession?
In economics, a recession is a period of temporary economic decline, generally defined by a fall in Gross Domestic Product (GDP) over two successive quarters, during which trade and industrial activity are reduced.
According to the Office for National Statistics (ONS.gov.uk), during the last UK recession GDP fell by 6% between the first quarter of 2008 and the second quarter of 2009. It took the economy five years to recover (1).
A recession is one of four phases in an endless economic cycle, from growth to peak to recession to trough (the bottom of the recession) – and then back again (2).
The four phases of the economic cycle
Recessions, which can be triggered by rising inflation, can cause a widespread drop in consumer spending.
They can also be caused by events such as financial crash, trade shock, adverse supply shock, an economic bubble bursting, and natural/environmental disasters (e.g.: major oil spills, the European BSE crisis).
The Covid-19 pandemic was a prime example of a trigger event that can cause a recession.
What is the Value Chain?
The Value Chain was developed by American academic Michael Porter (3), who is known for his theories on economics, business strategy, and social causes. He first introduced the value chain concept in his 1985 book “Competitive Advantage”.
He is also credited with creating Porter’s five forces analysis, which is instrumental in the development of business strategy, and is taught in marketing and economics courses.
The value chain addresses the fundamental logic of why an organisation exists by looking at how business inputs are changed into business outputs. The business outputs have a greater value than the input cost, which in-turn generates the organisation’s profit margin.
The simple formula for the profit margin is:
Value created and captured – Cost of creating that value = Margin
Value chain activities determine an organisation’s costs and affects its profits, whilst it can also determine how much a product will cost for the consumer.
Porter identified a chain of activities that are common to all businesses and divided them into primary activities and supporting activities, see the diagram below.
Porter’s Value Chain ©1985
There are nine key facets to the value chain. If one or more of those is weakened, for example via lack of resources or budget cuts, then this can have a detrimental impact across the whole business, and ultimately impact on the margin.
What is the Supply Chain?
The supply chain (4) is the network between an organisation and its suppliers who are involved in creating a product and delivering it to the consumer.
Links in the supply chain begin with the producers/suppliers of the raw materials and the links end with the delivery of the finished product to the end user.
The components of a supply chain can include producers/manufacturers, vendors, warehouses, transport and logistics, distribution, and retailers. Supply chain functions typically include product development, operations, finance, distribution, marketing, and customer service.
Supply chain management is crucial to optimising lower costs and for a more efficient production cycle. Companies constantly seek to improve their supply chains to keep costs to down and remain competitive in their markets.
Now that we have a basic understanding of a recession, the value chain, and the supply chain, we can look at how a recession can affect a business.
The domino effect of a recession
Recession can start a domino effect that spreads quickly and reduces confidence, causing…
- Decreasing demand for goods – During a recession many businesses and consumers will be more careful with their spending, resulting in a reduced demand for goods, or a similar level of demand but at a reduced price.
- Reduced profits – Largely due to the diminishing confidence the economy experiences. In summary, people buy less as they hold onto their money, because a recession makes a lot of things uncertain.
- Reduced cashflow – This third phase of the domino effect is because of reduced demand and reduced sales volumes. What can also happen is businesses extended their payment terms to their suppliers to hold onto their own cash for longer, which causes cashflow problems for their suppliers.
- Tightening of credit – In a struggling economy lenders are more reluctant to support individuals and businesses. In some instances, lines of credit can be forcibly reduced by banks, which can cause problems for businesses whose cashflow has slowed down.
- Declining stock prices and dividends - Companies that float on the stock exchange can see their share prices plummet, which can cause unrest among shareholders and potentially harm the reputation of a corporation and how it is managed.
- Operational changes - A silver lining of a recession is that many companies are challenged to do more with less, forcing companies out of their comfort zone and into making operational changes which can result in leaner, more efficient operations in the long-term. As an example, during the Covid-19 pandemic, many restaurant businesses changed the way they worked and began offering home deliveries. This is nothing new in the food industry, but for many fine dining restaurants, it was a step into the unknown that kept their businesses afloat and in some cases yielding greater profits.
- Staff layoffs – During a recession many people are at risk of losing their jobs and employers stopped hiring as they looked to cut costs due to falling sales demand. As the economy got smaller during the last UK recession, by the end of 2011 almost 2.7 million people were looking for work, with the quarterly unemployment rate reaching 8.4%, its highest since 1995 (5).
- Potential decline in quality – During a recession companies can be tempted to look to cut costs by using less expensive materials, and even replace skilled employees with relatively inexperienced staff. When companies offers less product for the same price, it’s called ‘shrinkflation’, which can be detrimental to a business in the long-term. Consumers tend to value quality and durability, so a decline in product quality can result in a decline in the perception of value in the eye of the consumer, which can last long after a recession has ended.
- Marketing constraints – When money is tight, it is common for the first budget cut to be to marketing spend. This typically stems from a lack of understanding of how important marketing is for business success. What should actually happen is the opposite and the marketing budget should be increased – provided it is used effectively – to gain market share from competitors who are tightening their belts.
- Price wars – Retail is a good example of how a recession can affect commerce and create a more competitive marketplace. In a competitive market, businesses will reduce prices in a bid to attract more customers in what is called as ‘a race to the bottom’. With a strong marketing strategy, a business shouldn’t need to lower prices too much, especially if the business provides high quality products and services. Consumers are very savvy and once a business cuts its prices it’s very difficult for the company to return to its previous higher prices and retain custom, which can result in long-term financial issues.
- Potential shortage of suppliers – Small businesses such as couriers or sub-contractors whose cashflow has slowed due to recession, or whose demand for their services has diminished, could unfortunately find themselves in a position where they can no longer continue trading. This can cause problems further up the chain regarding goods deliveries and the supply of raw materials.
How can a small business thrive during a recession?
When the economy is struggling, newspapers and news bulletins tend to focus on the negatives, which can compel people to tighten their belts in panic. Consumers purchase less and businesses extend their payment terms to suppliers whilst also using up their valuable stock to reduce outgoings and orders. This approach can compound the negative effects that a recession can have.
However, there are ways that small businesses can survive, and even thrive during a recession, and emerge from it with a leaner, more efficient business and sometimes with a broader client-base if diversification has been adopted.
How you can create a recession-proof business
- Build up your cash reserves – Slower payment schedules are common during a recession and can stifle cashflow. If possible, try and build up your cash reserves while your business is doing well so you can cover at least three months of trading expenses. This can help soften the blow to your business.
- Pay off your business debts – If you have to pay a lot each month to cover business debts rather than operating costs, then you could experience a problem during a recession. Clearing what you owe will relieve some of the pressure and free-up cash for other business expenses. You could even look at refinancing some debts into long-term agreements with smaller monthly payments. However, trying to do this once a recession has begun could be tricky as lenders may be less willing to refinance.
- Diversify – Analysing your sales for the previous couple of years will highlight where most of your revenue comes from. Is it a small percentage of clients? If so, this could be a problem for you if those clients stop buying your products and services or slow down their orders.
Diversifying could take you out of your comfort zone, but it may improve your business fortunes, both in the short-term and long-term. The digital age has made it easier for businesses to focus their efforts on social media and online paid advertising.
However, there’s still no substitute for face-to-face networking and developing strong business relationships. If you don’t already have one, developing a referral marketing strategy can help you survive an economic downturn and generate business for many years to come.
You might need to consult a marketing expert to help you develop a new referral strategy, but you could reap high rewards. As mentioned earlier in this article, one of the first areas where budgets are cut is marketing, which may reduce immediate costs, but it typically reduces sales and business awareness in your target markets.
In an article published by AdAge, they reported that businesses that cut their marketing spend during previous economic downturns lost market share and never regained it. They also went on to say that those who continued with, or even increased their marketing spend, lost less market share and recovered quicker once the downturn had finished (6).
- Keep control of your receivables - Taking stock of your receivables is vital to ensuring you have a good enough cashflow to survive an economic downturn.
• Ensure you have signed contractual agreements with all your clients. To ensure you are paid on time, you could insert a penalty percentage charge on any payments that are later than your agreed terms.
• If your client work is high value, then it is wise to take a deposit payment before starting any work. This will help to keep your cash flowing and ensure both parties maintain a vested interest in the work.
• Before you offer credit terms to your clients it’s a good idea to check their credit history. You can check a company’s credit report via services including Dun & Bradstreet and Experian. These services require a fee, which is small compared to your potential losses if a company leaves you with outstanding payments.
• Prioritise collecting all of your overdue invoices. You’ve delivered the goods and services, so you’re due the payment. If you continue to allow overdue payments you could struggle to recoup the monies due if the businesses in question fall into administration.
- Ensure tighter control of your costs–- When times are good, many businesses will spend more money to make more money. However, this approach can make it hard to build cash reserves, so it’s important to control your spending and take advantage of the best value goods and services you on the market.
A good rule of thumb is to ask yourself “do we really need this right now?” If the answer is no, then hold onto your money until you do.
- Look for new opportunities – There are many opportunities you can take advantage of in a recession that may not typically be available to you.
• Monitor your competitors - If you advertise your services, especially online, you’ll likely be up against your competitors. You may see less of their advertising during a recession, if that’s the case you can pinch some market share simply by continuing with your existing advertising.
• Sell or rent – If you have large office or warehouse space, or unused computers, you might think about sub-letting your extra space to other micro businesses and even sell your unused hardware to raise extra funds.
• Assess at your internal operations – Recessions are a good opportunity to look at your own in-house processes and to streamline your operations and remove any wastage. Doing this will make your business leaner and will help you to recover quickly from the effects of an economic downturn.
• Explore new markets, create new alliances or acquire other businesses – A recession can be an unfortunate time for many businesses, but this can create opportunities for other businesses to grow via strategic alliances and acquisition.
Can business insurance help during a recession?
Businesses of all sizes are affected by recessions, just on different scales. It’s important to ensure you continue to hold the correct levels of insurance and maintain your monthly premiums to protect your business assets, including: your staff, property, equipment, cash, furniture, vehicles, your reputation, and of course your customers.
Don’t be tempted to apply budget cuts to your insurance, either by cancelling policies or reducing the levels of cover to reduce your premiums. If you do and something goes wrong could inadvertently place your business in a worse position if you’re not adequately covered.
Some key insurances to protect your business are:
Office insurance - There is a range of covers available to you under the office insurance category, including buildings and contents insurance, business equipment cover, and business interruption insurance, all of which combine to comprehensively protect your property and assets against a multitude of risks.
Public liability insurance – This is a vital form of insurance if you deal with people, including your customers and your suppliers. The policy will respond to cover claims of accidental damage to property and claims that you caused an accident which caused an injury to someone.
Employers’ liability insurance – This is an essential form of cover to protect your staff. If you employ people you must hold this insurance by law, with a minimum of £5 million of cover. Employers’ liability will cover claims from an employee who has suffered an injury or illness as a result of the work they do for you.
Professional indemnity insurance - Professional indemnity claims can rise when money is tight as suppliers reduce their resources to cut costs and maintain profit margins. This can result in mistakes occurring, which can cost clients extra money to rectify, giving rise to claims.
Legal expenses insurance – Legal expenses insurance can provide cover for legal fees incurred when defending instances that some other liabilities insurances do not. These can include employment disputes including awards of compensation; defending against criminal prosecutions; property disputes and landlord disputes; tax investigations; regulatory compliance such as data protection defence; jury service and court attendance costs; and contractual disputes.
During a recession there is likely to be an increase in debts due to late payments throughout the supply chain. Legal expenses insurance doesn’t specifically cover bad debts, but if there is a breach of contract in relation to goods and services then this can give rise to a legal expenses insurance claim.
If you hold a legal expenses policy with us, you have access to Markel Law Solicitors 365 days a year, 24/7. You also receive access to the online Business Hub, which contains many useful guides, legal document templates, and links to help you run your business more effectively.
It’s important for businesses across the supply chain to communicate clearly with each other when times are tough. If each business knows the situation, they can then help each other, for example with temporary extended payment agreements. Clear communication and understanding can help to make your business relationships stronger in the long run.
Sources: 1. https://www.ons.gov.uk/economy/grossdomesticproductgdp/articles/the2008recession10yearson/2018-04-30
2. https://www.fidelity.com/learning-center/smart-money/what-is-a-recession 3. https://www.mindtools.com/pages/article/newSTR_66.htm 4. https://www.investopedia.com/terms/s/supplychain.asp 5. https://www.bhliving.co.uk/2018/05/01/economy-the-2008-recession-10-years-later
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