There is an old “saw” that that gets way overworked, and that is: “Every dollar of cost cutting falls directly to the bottom line.” Now, while this is true, most firms today are already operating in a fairly “lean” state – that is to say, they don’t have much “fat” to trim away. Maybe they don’t have any fat at all. If that is the case, then cost-cutting means trimming away at the “meat and bone” of their operations. Doing so will, inevitably, lead to a reduction in the ability of the organization to make more money in the future than it is making today.
Let me show you a better way.
Some definitions
Revenue (R) Income from sales
Truly Variable Costs (TVC) Costs that vary in a direct way with specific incremental revenues where the relationship can be clearly stated in a mathematical formula (e.g., x dollars per unit – as in raw materials; or n% per unit as in sales commissions) but not an estimate (such as an allocation of overhead expenses that are not truly and directly variable with incremental revenues)
Throughput (T) Revenue less Truly Variable Costs (T = R – TVC)
Operating Expenses (OE) All other monies paid out by the organization in support of the production of Throughput that cannot be classified as TVCs
Inventory or Investment (I) All the money tied up in the organization in support of the production of Throughput
Increasing Revenues
Besides the risk of cutting away “meat and bone” during cost-cutting operations that are so prevalent during economic down-turns, there is another very large down-side to cost-cutting in general. That is this: If you can cut costs or expenses to save – let us be generous – 5% this year, will you be able to do the same thing next year, or the year after that? Likely the answer is no.
After all, there is a finite limit to cost-cutting. The ultimate in cost-cutting is to simply cut your costs to zero, close the company and go home!
However, there is no theoretical upward limit to increasing revenues. No company has ever become an industry leader through cost-cutting. Companies gain industry leadership through finding and leveraging a competitive advantage that provides value to customers while employing labor and capital effectively.
So, let us consider what happens when a company increases revenues by five percent in lieu of cutting costs by that same five percent:
Scenario Number 1: A Five Percent (5%) Increase in Revenues | |||||||||
All Values in 1,000's | |||||||||
Year 1 | Change | Year 2 | |||||||
Sales | $ 50,000 | 5.0% | $ 52,500 | ||||||
Direct Materials | $ 20,000 | 40% | $ 21,000 | ||||||
Operating Expenses | $ 26,000 | $ 26,000 | |||||||
Inventory | $ 10,000 | $ 10,000 | |||||||
Total Assets | $ 30,000 | $ 30,000 | |||||||
Net Operating Income | $ 4,000 | 37.5% | $ 5,500 | ||||||
Metrics | |||||||||
Net Profit | 8.00% | 31.0% | 10.48% | ||||||
Return On Assets | 13.33% | 37.5% | 18.33% | ||||||
Cash Flow (Note 1) | $ 4,500 | 33.3% | $ 6,000 | ||||||
Note 1: Assumes $500 in amortizations | |||||||||
Here we have a $50 million-a-year company that grows its revenues by five percent. They have direct materials costs (read: TVCs) that average 40% and operating expenses of $26 million annually. To complete the picture, the firm carries $10 million in Inventory and has total assets of $30 million. Increasing their revenues by 5% increases the firms bottom-line by a hefty 37.5% (from $4 million to $5.5 million). Net profit zoomed upward 31% and $1.5 million in cash was liberated in the firm. (Cash is always good – especially in a recession.)
Leaning the inventory
Now we will take another look at how to make more money even if you do not believe that you can presently increase revenues. What happens if our example company reduces their inventory by 20 percent?
Scenario Number 2: A 20% Decrease in Inventory | |||||||||
All Values in 1,000's | |||||||||
Year 1 | Change | Year 2 | |||||||
Sales | $ 50,000 | $ 50,000 | |||||||
Direct Materials | $ 20,000 | 40% | $ 20,000 | ||||||
Operating Expenses | $ 26,000 | -2.0% | $ 25,500 | ||||||
Inventory | $ 10,000 | -20.0% | $ 8,000 | ||||||
Total Assets | $ 30,000 | $ 28,000 | |||||||
Net Operating Income | $ 4,000 | 12.5% | $ 4,500 | ||||||
Metrics | |||||||||
Net Profit | 8.00% | 12.5% | 9.00% | ||||||
Return On Assets | 13.33% | 20.5% | 16.07% | ||||||
Cash Flow (Note 1) | $ 4,500 | 66.7% | $ 7,500 | ||||||
Cash flow includes (a) cash liberated from inventory, plus (b) cash savings in operating expenses based on 25% carrying cost of inventory reduction. | |||||||||
Note 1: Assumes $500 in amortizations | |||||||||
This looks pretty good, too, does it not? By reducing our inventories, we also reduce our carrying costs. Carrying inventory at this company costs about 25 percent annually (or about $500,000 per year). This alone adds 12.5 percent to the bottom line. But here is the big gain: $2.5 million in cash is liberated -- $2 million from the inventory reduction itself and another $500,000 from the reduction in Operating Expenses. (Remember: Cash is a good thing – especially in a recession!)
The double-whammy
What does this company look like if they both increase revenues by five percent and are able to cut their inventories by 20 percent?
Scenario Number 3: A Five Percent (5%) Increase in Revenues + A 20% Decreae in Inventories | |||||||||
All Values in 1,000's | |||||||||
Year 1 | Change | Year 2 | |||||||
Sales | $ 50,000 | 5.0% | $ 52,500 | ||||||
Direct Materials | $ 20,000 | 40% | $ 21,000 | ||||||
Operating Expenses | $ 26,000 | -2.0% | $ 25,500 | ||||||
Inventory | $ 10,000 | -20.0% | $ 8,000 | ||||||
Total Assets | $ 30,000 | $ 28,000 | |||||||
Net Operating Income | $ 4,000 | 50.0% | $ 6,000 | ||||||
Metrics | |||||||||
Net Profit | 8.00% | 42.9% | 11.43% | ||||||
Return On Assets | 13.33% | 60.7% | 21.43% | ||||||
Cash Flow (Note 1) | $ 4,500 | 100.0% | $ 9,000 | ||||||
Cash flow includes (a) cash liberated from inventory, plus (b) cash savings in operating expenses based on 25% carrying cost of inventory reduction. | |||||||||
Note 1: Assumes $500 in amortizations | |||||||||
These numbers sing, don’t they? A 50 percent increase in Net Operating Income as it soars from $4 million to $6 million, showing a 42.9 percent increase in Net Profits and liberating an astounding $4 million in cash.
What does it take?
Get these kinds of results takes nothing more than understanding your business in ways you have not previously understood it – as a system. All you need to do is get you and your management team to understand and fully agree upon those few things that need to change in order to:
· Increase Revenues or Throughput
· Decrease Inventories or other demands for new Investment
· Cutting or holding-the-line on Operating Expenses while supporting substantial growth
I can help. Contact me at rcushing(at)geewhiz2roi.com and get started today.
©2010 Richard D. Cushing
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