Right now, smart entrepreneurs everywhere are creating emergency action plans. They have to. Their companies' survival depends on it. It's what great leaders do.

The tough reality is, when earnings fall below a certain point, the only solution is to stem outgoing cash flow. For most firms, that translates to payroll cuts. It's difficult and painful, but it's also unavoidable when you're operating in survival mode.

Once the decision is made to cut personnel costs, there are three components to a payroll-cutting action plan: who and what to cut, when to cut, and how to minimize the damage to survivors.

1. What Are Your Options?
When most people think of payroll reductions, they think in terms of layoffs. It's a sure-fire way to cut operating costs, but it's also the most traumatic. If you do it, check your emotions at the door. That's why it's wise to plan in advance, as opposed to when you're in a panic.

How do you determine who stays and who goes? Decisions should be based on employee capability, not on seniority or on who needs a job most. Rank your employees according to their contributions. Create a list, starting with your most productive workers and working down to the most marginal. If you have to start cutting, you'll know where to start.

Remember, however, that you have other options:

  • Declare a four-day work week: Moving from five days to four will generate an immediate 20 percent payroll deduction. And unlike layoffs, it affects all employees equally, which is more palatable for many employers.
  • Reduce wages: If you're going to cut wages, do it across the board. One way to make reductions more endurable is to build in performance-based incentives. In other words, give employees the opportunity to earn more if the firm hits specific revenue goals.
  • Turn full-timers into part-timers: By doing so, you'll not only reduce wages, but also save on fringe benefits and vacation time. Fringe benefits are only reduced if employees work less than enough hours, per state, not to be considered full-time employees. Remember, you're still obligated to honor vacation earned from past full-time employment.
  • Enact furloughs: Ask each of your employees, in rotation, to take an unpaid leave of absence for a specific number of weeks.
  • Suspend bonuses: Depending on what portion of payroll is paid in bonuses, suspending them can generate big cost savings. To be fair, make sure to announce the suspensions in advance of the bonus period.

Obviously all of these are tough on employees. But with unemployment at more than 8 percent and rising, most workers would agree that having something is better than nothing.

2. When Should You Cut?
Once you determine what emergency actions you'll take, identify your tipping point for setting that plan in motion. This is your point of no return: If business falls to X, then you'll enact Y.

It's up to you to determine your business's threshold. Every business has its own critical initiation point for its emergency action plan. The items you might want to consider are cash level (including receivables), inventory level, aging of outstanding bids, number of bids and backlog in hours or dollars.

The point is, when you set an objective, measurable point of action, you remove some of emotional upheaval from the process.

3. How to Minimize Damage
Whatever form of payroll reductions you make, recognize that your employees will be traumatized. It's up for you to set the tone. The best approach is to be positive and upbeat, but truthful about the challenges facing your company.

When announcing cutbacks, look your employees in the eye. Be frank, be real and appeal to their sense of reason. Validate what they may be feeling and remind them of the greater economic picture: "I know you're disappointed. I'm disappointed, too. But people in the unemployment line have even greater hardship then we do."

Leadership starts at the top. When asking employees to make financial sacrifices, you must make those sacrifices, too. Your people must see that you share their pain.

In the days that follow, practice "MBWA"--management by walking around. Maintain close contact with your employees. Ask them how they're doing, and let them know how the company is doing. Build a sense of purpose and possibility: "We have to work together and pull through this as a team." Leading by example is the best way to lead your company out of difficult times.