Shifting into Cost-Cutting Mode

Back in 2002, Scott Chatel's business remodeling brownstones and apartments in Brooklyn and Manhattan was so good that he set a goal to increase annual sales from $2 million to $5 million by 2005. He signed a three-year lease and renovated new office space, expanded his staff, and printed four-color brochures. His firm, Chatel Contracting, was busier than ever, but the costs of expansion erased Chatel's profits, leading him to take on debt. "It was the overhead that was doing us in. The jobs were always profitable," Chatel says. By the end of his lease in 2005, Chatel dropped his expansion plans and went into cost-cutting mode.

Many small business owners may soon find themselves in Chatel's situation, with rising costs and stagnant sales in a sour economy. Recent surveys of economic trends by the National Federation of Independent Business found weak levels of capital spending over the past six months. And in its latest survey, conducted in September, just 21% of respondents expected to make capital purchases in the next few months. The survey also found businesses reducing inventories, with a net 12% cutting stock rather than adding. While business owners are nervous about the economy, many have refrained from more drastic cuts or layoffs, says Jennifer Rockne, director of the American Independent Business Alliance, based in Bozeman, Mont. "The local folks are typically very reluctant to lay anybody off because a lot of their employees tend to be longtime employees," she says.

Still, by recognizing the problem early and making moderate reductions, small firms can avoid more severe cuts later on, financial experts say. Companies that ignore warning signs can erode their profits with rising costs, and those that borrow to meet those costs can wind up insolvent.

Financial Ratios Give Warning

Chatel took serious steps to cut his overhead. He gave up his office space—gutting the $50,000 renovation he had done when he moved in—and moved the office back into his home. Instead of laying people off, Chatel left vacant positions unfilled until his staff shrank from 15 to five—about the number of employees he had before expanding. He went from doing 60 jobs a year to just 13, and he cherry-picked the most profitable ones that wouldn't require subcontractors. With the help of a workout firm, Paramus (N.J.)-based Corporate Turnaround, he negotiated payment plans with his creditors.

Today Chatel's sales are down to $700,000, but the firm is far more profitable because of his cost-cutting measures. Eliminating the office saved $500,000 a year in expenses. "Sooner or later you have to know when to say enough's enough," he says. Chatel counts himself lucky for acting when he did, but many small business owners don't see their financial troubles coming. "A lot of [businesses] are financially ill but don't even know it until it's too late," says Sam Bornstein, a CPA and professor of accounting at Kean University in Union, N.J.

Bornstein advocates using financial ratios as an "early warning system" to signal when a business should cut costs or make other adjustments. Comparing indicators like the gross profit ratio—which shows the proportion of profits to total sales—to industry averages can tell business owners whether their costs are too high or their prices are too low. Other ratios can show whether overhead costs are too high, even if individual transactions are profitable. Bornstein says having an accountant check such figures annually will show business owners signs of trouble before they take on too much debt to cover growing costs.

Taking New Measures

Robert Welton wishes he had acted to cut costs earlier. His eight-year-old company, WelTec, based in Egg Harbor Township, N.J., builds and maintains infrastructure for telecom and cable companies. His business was doing well in early 2006, with sales of $3.