05 March 2010

The Right Cost-Cutting Formula

TOC Profit
The formula above is the only real formula that should be considered by companies considering cost-cutting during this recession.

Here is what the formula means.

The upper-case Greek letter delta (the triangle-shaped character) is used in mathematics as a symbol meaning “the change” or “difference.” Therefore, we read this formula as follows:

The change in P = the change in T minus the change in OE,
where P = Profit, T = Throughput and OE = Operating Expenses.

Throughput (T) is defined as Revenue (R) less Truly Variable Costs (TVCs), and TVCs are further clarified as only those costs that vary directly with incremental changes in Revenues. For example, raw materials probably vary directly with changes in unit sales of a manufactured item. However, production payrolls do not vary directly with changes in Revenues. If your firm produces 1,000 widgets this week and only 850 next week, but 1,200 last week; chances are the production payroll was substantially the same for each of these weeks.  Therefore, production payroll cannot be classified as a TVC.

Substituting for T

Since T = R – OE, we can substitute into our formula and make it read like this:

The change in P = the change in R minus the change in TVC minus the change in OE

Thinking about cost-cutting

Based on this formula, we can safely state the following:
  • An increase in R will result in an increase in P, provided there is no change in TVC or OE
  • A decrease in TVC will result in an increase in P, provided there is no change in R or OE
  • A decrease in OE will result in an increase in P, provided there is no change in R or TVC
Where executives get into trouble during recessions
Pay attention to the “no change” clauses in the three statement above. These are critical, but all too frequently overlooked by executives and managers in making cost-cutting decisions. We just saw a terrific example of this with Toyota.

Some executives at Toyota thought that they could increase P (profits) by reducing TVCs through the purchase of lower-priced components for their automobiles. For a while, it probably worked. However, in February 2010, Toyota’s year-over-year sales for the month were down 43%, and for the first time in several decades, Ford Motor Company sold more units than Toyota in a calendar month. This is not to mention the fact that some billions of dollars will be expensed by Toyota over the coming months and years due to the recall.

So, what were the affects of Toyota management’s decision to reduce TVCs in order to increase Profits?
  1. Revenues down 43% year-over-year
  2. Several billion dollars added to Operating Expenses (OE) due to recall effort
  3. Lost customers, which will require additional expenditures in OE (marketing) to reclaim
  4. Additional expenditures in OE (public relations, legal, etc.) for damage control
Think it through
It is a simple thing for executives in a firm facing recessionary pressures think, “We will cut our operating expenses (OE) by laying off some people,” without considering the long-term affects that the move may have on customer satisfaction, for example. How many customers will be lost due to the cut-back in staffing? How much more will need to be spent in OE (sales and marketing, for example) to maintain the same levels of revenue as a result?

Use the formula

If, as an executive, you are considering cost-cutting, then consider the whole formula. Go over it with your management team. Carefully consider any short-term and long-term impact on Revenues and Operating Expenses. Do not simply assume that you can change one factor and the others will remain unchanged.

Contact me!

©2010 Richard D. Cushing

No comments: