In a LinkedIn group discussion today, many people were offering advice regarding how to save a small business that has been struggling due to the recession. There has been no shortage of advice. However, one comment today really stuck out to me. Here is what the contributor had to say:
A company is making 1 million a year.
From that it makes 10,000 profit (1%).
Each sale yields 25% return - i.e. if you sell 1,000 250 is profit.
To double its profit it can:
1. Reduce costs by 10%
2. Increase sales by 40%
Do the math(s). Which is easier?
Now, perhaps this example was intended to demonstrate what a clearly bloated and, likely, wasteful company really looks like. After all, the firm is grossing $250,000 on $1 million in revenues, but net profits are only $10,000 (1%). That means that the firm is spending $240,000 (99%) on “expenses.”
If this is true – that the company really is bloated and wasteful – then, by all means, the quick and easy way to making more money is to “reduce costs by 10%.” It may even be likely for a $1 million revenue company that is spending $240,000 in expenses that $24,000 could be cut out and not do a bit of damage to the firm’s ability to survive and thrive.
The real state of things
For better or for worse, most small businesses today do not have a profit-and-loss statement that looks anything like that – at least not in terms of being bloated and wasteful. Most of the SMBs (small-to-mid-sized businesses) that I encounter are already running a pretty tight ship. There is no extravagance left in the firm’s operating expenses and, typically, they have already cut back on staffing so that many of the folks in the organization are working long hours and have taken on multiple duties so that fewer people are needed to keep things running. These organizations do not have any “fat” left to trim away. If they seek to cut expenses by even five percent (5%), it would mean cutting away “muscle and bone” – the strength that has allowed the organization to survive until today.
Cost-cutting may have gotten here
If management in such organizations are trapped in cost-world thinking, it could be that cost-cutting is what helped bring them to the brink of destruction, as it is. Here is how cost-world thinking can take a executives and managers astray and lead them to make decisions that are damaging to the organization:
Misleading allocations of overhead expenses
Using the figures offered by the contributor to the discussion (above), this company believes it has a gross profit of 25% ($250 for every $1,000 in revenues). Let us say that this is being calculated in the following (traditional) manner:
| Cost Classification | Cost Amount |
| Raw materials | $250.00 |
| Direct Labor | $100.00 |
| Allocation of indirect costs and overhead | $400.00 |
| Total Calculated Cost of Product | $750.00 |
For the sake of simplicity, let us say that each “widget” sells for a price of $1,000, so we have the following:
| Amount | |
| Unit Revenue | $1,000.00 |
| Unit Cost (incl. allocations) | $750.00 |
| Calculated Gross Profit per Unit | $250.00 |
Also, let us assume that, due to the recession, this company also has excess capacity at this time. (Otherwise, how could their operating expenses possibly be $240,000 on revenues of $1 million?)
Opportunity knocks
Now, one of this firm’s salespeople comes back from a long discussion with a potential new customer in Europe. This firm wants to buy up all the remaining capacity at the firm. That means 1,200 units. However, they are only willing to pay $650 per unit. What should the company do?
Far too many executives caught up in cost-world thinking would turn this offer down. They would say, “We can’t take a loss of $100 per unit and ‘make it up’ in volume! That’s crazy!”
But, let us look at what is really happening. The company already has excess capacity. It could produce the additional 1,200 units without investing in any new facilities or equipment. Furthermore, it would not add to operating expenses, because no additional back-office staff would be required and no overtime is expected to meet the new demand. So, here is a contrast between cost-world thinking and reality:
| COST-WORLD THINKING | Amount |
| Unit Revenue | $650.00 |
| Cost-world Cost | $(750.00) |
| Gross Margin per Unit | $(100.00) |
| Number of Units Sold | 1,200 |
| Gross Profit from Offer | $(120,000) |
| Gross Profit from Current Operations | $250,000 |
| Total Gross Profit | $130,000 |
| Operating Expenses | $(240,000) |
| Net Profit | $(110,000) |
Throughput Thinking
| THROUGHPUT THINKING | Amount |
| Unit Revenue | $650.00 |
| Truly Variable Costs (TVCs) (Raw Materials) | $(250.00) |
| Throughput per Unit | $400.00 |
| Number of Units Sold | 1,200 |
| Change in Throughput from Offer | $480,000 |
| Throughput from Current Operations | $250,000 |
| Total Throughput | $730,000 |
| Operating Expenses | $(240,000) |
| Net Profit | $490,000 |
Escaping from cost-world thinking
Here is a simple formula to help rescue firms from making the error we have illustrated above:
Where ROI = Return on Investment,
delta-T = Change in Throughput, where T = Revenue less Truly Variable Costs (TVCs),
delta-OE = Change in Operating Expenses, and
delta-I = Change in Inventory or Investment
In this case, we have determined that the change in OE = zero, and for simplicity’s sake, we have also assumed that the change in Inventory or Investment is zero (or negligible).
Essentially, when looked at properly this offer to “sell below cost,” actually increases the firm’s net profit by $480,000 with virtually zero investment. (In a real situation, some change in inventory is likely, but the effects would still be small.)
I trust this sheds new light on your business situation. Contact me at rcushing@GeeWhiz2ROI.com if you’d like to have help getting a better view of your business and how to make more money.
©2010 Richard D. Cushing
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