Тег: Consultation

Case study on the crisis in mechanical engineering

Miloš

The economic crisis that began in 2014 hit the Russian mechanical engineering industry hard. Compared to 2008, the situation for enterprises was complicated by political sanctions against Russia. On one hand, the twofold drop in the ruble became a positive factor, increasing the cost of similar foreign machines and reducing competition in the domestic market for domestic producers. On the other hand, imported components, on which the production of Russian equipment heavily depends, became more expensive. The cost of mechanical engineering products rose. Manufacturing plants became concerned with import substitution, but so far this task has not been solved.

Another negative factor was the decline in economic needs. With the exception of orders placed by the military-industrial complex and state corporations, the rest of the market slumped sharply. Total demand for the products of mechanical engineering companies decreased more than it did in 2008.

Unlike our enterprises, foreign companies quickly reoriented and began to additionally stimulate demand for their products in Russia by introducing new financial services. They began providing buyers with unprecedented discounts, long-term interest-free installments, leasing, and practicing other methods to stimulate purchasing activity.

In the crisis situation, domestic companies chose different tactics. A number of enterprises (for example, a crane manufacturing plant in Chelyabinsk) diversified sharply, changing their assortment and concentrating efforts on exports and working with key clients. However, most mechanical engineering companies preferred to sharply reduce the amount of products manufactured, focusing on various ways to optimize expenses and reduce costs.

One of the enterprises caught in the whirlwind of these economic events and experiencing the negative consequences of the crisis was the Mashinstroy holding (name changed).

About the company

The Mashinstroy production holding has a long history and tradition. It includes production enterprises, a design bureau, and its own sales unit. The holding produces tractors, municipal equipment, bulldozers, and special-purpose equipment for the military-industrial complex with a fairly wide range of modifications. It is one of the few mechanical engineering companies in Russia that has preserved the engineering competencies and production base necessary for producing modern products.

Sales Market

Mashinstroy works with customers from Russia and small developing countries, to which sales are carried out largely through political channels. The competitive environment in which it offers its products is not very saturated. On one hand, there are Western manufacturers, whose equipment, after the fall of the ruble, exceeds the cost of similar products from the holding by 30% or more; on the other, there are Chinese plants, whose equipment is lower in quality and currently not widespread in Russia.

Management

The mechanical engineering holding consists of a number of independent enterprises located in different regions of Russia. They are managed by a management company located in Yekaterinburg. The powers of plant directors are limited to solving only operational issues. All strategic tasks are formed in the management company. In most cases, all communications between enterprises were also carried out through the management company.

The formalized development strategy of the mechanical engineering holding became irrelevant under the current conditions. A new anti-crisis strategy has not been adopted. In this situation, each head of an enterprise within the holding independently seeks solutions to exit the crisis.

Finances

A high level of fixed costs remained in the holding. At the same time, product output dropped sharply, leading to a fall in turnover and profitability. High indebtedness and the inability to take new bank loans increased the need for working capital. For this reason, the deadlines for several contracts were missed. Against this backdrop, financial flows decreased even further.

Personnel

As a result of the reduction in production volumes, salaries fell in most divisions of the holding. Key specialists began to resign. The level of motivation and engagement of personnel dropped sharply. Gradually, some enterprises began switching to a part-time work week, which served as another push for the resignation of several important specialists.

Products

The range of products is quite wide: municipal, agricultural, quarry, and construction equipment. In addition, a number of enterprises have competencies in producing military equipment. The engineering company constantly develops new equipment, including innovative types. New modifications of existing products are constantly being developed, and models that have proven themselves in the market are being updated.

General Situation

Starting from 2014, the situation in the holding has been constantly deteriorating. A shortage of working capital makes it impossible to ensure the deadlines for existing contracts. Despite the demand for the holding’s equipment, the ability of the enterprises to meet the needs of the mechanical engineering market has also decreased. Parallel to this, the capacity of the Russian market is shrinking.

In the absence of an actual strategy in the field of sales and marketing, a large amount of work-in-progress has accumulated, which, against the backdrop of a shortage of working capital, further exacerbates the situation of the mechanical engineering holding.

With rapidly falling turnover, the holding’s fixed costs remained at the previous level for quite a long time. Profitability began to drop rapidly, going into the negative within a year. Having a large loan portfolio, the holding began to delay loan payments. Delays in salary payments appeared in each of the business units at the enterprise.

Questions

  1. What solutions do you see for bringing the Mashinstroy holding out of the crisis?
  2. How should these solutions be integrated into the overall development strategy of the holding?

Answer

1. What are the downsides of this type of enterprise organization, such as a holding? First and foremost—transfer pricing. The owner of a holding always has the temptation to sell the products of one of their enterprises to another of their enterprises not at a market price, but at an undervalued one. What does such a protectionist policy lead to? Exactly the same thing that protectionism at the state level leads to. The holding’s enterprises become less competitive compared to their direct competitors in the global market, as they may not care much about sales. Why bother if the buyer is “one of their own”? They will buy anyway.

During a period of economic growth, this all seems like trivia, but in a crisis, there are no trivialities.

Thus, the first and obvious direction of optimization is increasing the autonomy of the holding’s enterprises.

2. A crisis is always characterized by a decrease in the share of CAPEX and an increase in the share of OPEX in enterprise budgets. So, the second obvious direction of optimization will be reorienting from the finished products market to the production of spare parts, warranty and post-warranty service; as for finished equipment, the goal should be not so much to fight for the shrinking Russian market as to push into the global market with all possible strength.

3. A strong point of Russian mechanical engineering is still a fairly powerful design school. It makes sense to negotiate with the Chinese about production in China based on Russian projects. Yes, this means that the holding’s design units act directly to the detriment of the production units. From the perspective of social obligations, it is not very “comme il faut” to reduce labor-intensive production, but from the perspective of the holding owner, developing a potentially more high-margin research and design direction is certainly profitable.

4. When the price of labor drops even further compared to the Chinese, production in Russia can be resumed, and “made in Russia” mechanical engineering products can be sold in the Celestial Empire, which sounds fantastic for now, but the Russian leadership is confidently moving the country in exactly this direction. Of course, this will mean the entry of Chinese comrades into the capital of the corresponding enterprises of the holding. It is also possible that the enterprises could be offloaded to them entirely, and even for a relatively decent price. Of course, this move might not work, because you never know exactly when the state will decide to tie the hands of a drowning man, imagining he actually intended to save himself. However, this caveat applies to absolutely any step taken by a legal business, so it is not necessary to repeat it every time.

5. A lack of working capital means that strategic investors must be sought. For this, it may be necessary to take some of the holding’s enterprises public through an IPO, which, in essence, would mean their exit from the holding while the current owner retains, say, a blocking package of shares. In return, refinancing, a change to more effective management, and involvement in new technological and sales chains could give these enterprises a development impulse, and for the current owner, mean a transition from losses to profits.

A case about stealing a business

Miloš

The Setup

A scientist and talented manager, let’s call him SM, headed an experimental laboratory at the sunset of Soviet power, and after 1991, created a private firm to monetize its scientific developments. The partnership proved successful. A clientele emerged, placing commercial orders, and a steady flow of cash followed. The scientists’ earnings increased, and it became prestigious to enter the laboratory, including for the purpose of defending a dissertation. In the new economic conditions, SM strengthened his good name—his personal brand, as they say now.

The scientist was wise and understood that he would not live forever; in the mid-2000s, well into his sixties, he chose his best student (BS) as his successor, who owed the boss a great deal. They verbally agreed that after a few years, the teacher would hand over his scientific post and a share in the business to the student under certain conditions. Until that happened, the successor was appointed as SM’s deputy with signing authority.

Time passed. But the “grandfather” aged slowly. On the contrary, developing an enviable energy, he managed to marry yet again—this time a young (very young and beautiful) student, a PhD candidate from the provinces. SM intensively began arranging the life of his new family: he solved the housing issue on a large scale, started traveling to resorts with his young wife, took up downhill skiing in his old age, and meanwhile devoted less and less time to work. But business was going well: the deputy did not let him down, and money arrived in SM’s account regularly. Commercial orders grew, and the laboratory was strengthened by new staff brought in by BS. For his part, SM did not mistreat the future successor and, as he believed, paid him generously, very generously. Everything was fine; for the boss, a warm, almost “Boldino” autumn had begun.

The Climax

However, complex and unpleasant questions were accumulating in the deputy’s soul, such as “how long must I wait?”. He had the same thoughts as Pushkin’s Onegin regarding the uncle who was, as is well known, of the most honest rules. The best student continued to remain No. 2, although he was eager for the No. 1 position. BS could not ask the boss directly when he would take over. Yet he received indirect signals from SM that the agreements were still in force. The message was: wait, my friend, and happiness will be yours; meanwhile, our business is my personal business.

Not immediately, but BS realized it was time to stop worrying and start acting. He began with something simple: creating his own client base by poaching his boss’s clients. He registered his own company and nudged customers toward the idea that, for tax reasons, the contract for the work should formally be concluded with his company rather than the boss’s firm.

Over time, BS attempted to switch the largest companies to himself, whose executives knew SM personally. They signed the documents, extending the trust they had in the teacher’s name to the student. Perhaps everything would have slipped through here as well, but every now and then BS began to let slip in conversations with old clients that he, BS, was actually conducting all the business in the scientific company, while the “grandfather” was useless. He claimed the boss was pushed around by his young wife, understood little about the business, and it was long past time for him to retire. All of this did not escape the attentive ears of the interlocutors. Some of them informed SM in polite terms about the danger he had failed to notice, being preoccupied with an intensive family life.

The Resolution

Several years passed this way. SM’s wife successfully defended her dissertation and, through patronage, obtained a very good position, remaining as young and beautiful as ever. The same could not be said for her husband, who had crossed the threshold of his seventies. He remained impeccable in providing for the family’s material needs, but he could no longer maintain the greatly increased spiritual and other needs that such a beauty craved and undoubtedly deserved. However, some other men, far from being Doctors of Science, were quite capable of providing these other needs. The professor eventually reached this discouraging conclusion after connecting the corresponding dots. The family life cracked and quickly came to a logical end. The spouses separated, and in doing so, the wife managed to secure the enviable shared living space as a memory of her husband.

The teacher, left alone, was as if waking from a faint, and after a short period of reflection, returned to his laboratory—or, to put it in modern terms, to business. His business. It turned out that his professional skills had not vanished; his favorite work not only comforted him but again began to bring pleasure. But the euphoria of the return did not last long, only until SM conducted a detailed analysis of the orders and contractual relationships. First, suspicions arose that orders were disappearing somewhere, and then he looked at the documents, quickly remembered the warnings of his friends, and met with them. The truth revealed itself to him in all its harsh guise, and he finally understood, turning to the facts, that his deputy was brazenly and effectively openly stealing his business.

A conversation took place between the teacher and the student, if it could be called a conversation. After that, having calmed down and reasoning concretely as businessmen—but without the extremism sometimes characteristic of businessmen (they were, after all, intelligent people)—SM and BS realized they were in a difficult situation and began to think about how to live further. Initially, each saw emotional arguments for an immediate and harsh “divorce.” But upon more detailed analysis, factors emerged in favor of continuing cooperation, whatever that might entail.

Meanwhile, the rift between SM and BS became exposed, consequently alienating the employees. Strangely, the battle line was drawn not between the “old” and “new” staff brought in by the boss or his deputy, but along the moral positions of the parties, mainly on the question of who cheated whom. Furthermore, the confusing scheme of how orders were processed began to affect the quality of the work. Mistrust grew among clients toward the laboratory, its head, and the deputy: from the outside, it was impossible to tell who was right and who was wrong. Other negative factors appeared, which ultimately led to a weakening of the flow of orders and affected the financial situation of the employees.

With each passing day, the situation became worse…

Questions

  1. How should the characters in the case have acted to avoid such a situation?
  2. How can the current conflict be resolved? What would you recommend SM and BS undertake to reach an agreement?
  3. Is it possible to preserve the profitable business created by SM in such a situation? How can this be done?

Constraints. The company owner is already over 70 years old. Even if he returns to the operational management of the business, he will not be able to engage in the company’s development for long. Additionally, it is important to note that the private research firm was created thanks to the owner’s authority and connections based on a state laboratory. One part of the business cannot exist without the other.

Answers

1. How should the characters in the case have acted?

As is easy to see, all the misunderstandings in the given case arose due to vague agreements. The first vague agreement: BS is forced to do all the work for a salary, based on a promise to inherit the business in an undefined future. The second vague agreement: the absence of a prenuptial agreement and, consequently, a conflict of expectations between SM and his spouse. The third vague agreement: the dubious legal status of the entire business, since officially it all remains a laboratory within a state research institute, and it is precisely this legal form that forces the first agreement to remain vague.

It is clear why SM preferred to stay under the wing of the state in the early nineties: it provides enormous savings at a stage when the business has not yet stood on its own feet. Here you have premises in the institute at the budget’s expense, plus a wealth of various informal connections in state structures of different levels, which can be used to pull off various schemes.

In the new post-Soviet economic reality, passing on the position of laboratory head as an inheritance is somewhat archaic. The timely establishment of a more adequate company structure could have provided the tools to prevent the conflict between SM and BS. For example, SM could have received a share in the business in addition to a salary and gradually increased it. The business itself could have been scaled more confidently instead of being confined to the size of a laboratory—but that, of course, is a matter of taste, ambition, and market conditions.

In general, the only task of a business owner that cannot be delegated to managers is controlling that management does not plunder the business. If the business owner does not perform this single task, then he alone is ultimately responsible for the business slipping through his fingers. To the extent that the state can be likened to a commercial company, the people are certainly responsible for the appalling quality of state management and the plundering of state property into the pockets of civil servants—but that is an off-topic in this case.

Thus, if regarding the business, the solution lies in removing it as completely as possible from state regulation, then regarding marriage, such things are not permitted by family codes. According to the code, a prenuptial agreement cannot provide for economic sanctions for extramarital affairs, which makes SM’s position in this deal more vulnerable. However, this is not so important. All agreements could have been concluded in advance. On the other hand, such romantic infatuations in old age are inevitably accompanied by a certain affectation, so it would be strange to expect a sober view from SM during the “mating season.”

By the way, if the company had been separated from the research institute in its time and represented an independent business, the appearance of SM’s spouse on the horizon would have inevitably led BS to demand clear guarantees of receiving the business; otherwise, it would have by default passed as inheritance to SM’s spouse, without all these dances with appointing a new lab head at the scientific council.

2. How can the current conflict be resolved?

I would advise formalizing the separation of roles. SM remains the lab head in the research institute until he decides to retire, and also holds the status of a scientific consultant with a good salary in BS’s company. BS retains his position as head of sector (or whatever it was) in the boss’s lab and remains the general director of his own company. As for what form to keep SM’s company in, I won’t venture a suggestion. Management could be transferred to BS. One of the companies could be liquidated. They could be merged into a holding. It’s not fundamental.

The point of the proposed solution is that each party has tools against the other, but no incentive to use them without extreme necessity. SM continues his scientific work, which should have a positive effect on his mood and zest for life, and the salary in BS’s company will allow him to continue living in style, as he is used to. At the same time, he no longer needs to ensure the business is not being plundered, since the business has already been transferred; only the rent remains. BS retains all clients and operational management, which means he has guarantees of maintaining control over the business and incentives to develop it in every way. He could fire SM, but then he would lose his position in the laboratory.

What am I doing wrong?