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Why
is it so important to understand cost dynamics? Because costs have gotten a
bad reputation. You probably tend to consider costs as negative influences on
your business, something you must reduce at any “cost.” Look more closely,
and you will begin to understand that not only are costs necessary but they
may be utilized as strategic weapons to reinvent your company’s competitive
advantage.
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Cost
Reductions – Always a Good Idea?
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Some cost reductions have little or no impact to the company’s
operation, such as a reduction in rent or reductions based on efficiencies.
Others may have a ripple effect throughout the organization.
Many owners fail to understand that “costs” are an assemblage of different
forces that behave according to business activity. Some costs are fixed and
will not change when there are small to moderate sales increases or
decreases. Other costs rise and fall according to sales activity. Here is the
beginning point to better understanding cost dynamics.
Many people are familiar with those corporate management memos dictating the
requirement to reduce departmental costs by 10% or else. Unfortunately,
oftentimes these reductions, if not measured, may have a direct or indirect
detrimental effect on personnel, customers and revenue.
Consider the manager of accounts receivable who receives such a memo and
decides to reduce staff and consolidate collection regions to reach the 10%
budget requirement. Five regions are now to be consolidated into three
resulting in a 65% increase in workload across the three remaining regions.
While the salaries and benefits associated with two headcounts have been
reduced, company-wide collections of receivables slows from an average of 34
days to 39 days – an 18% increase in average collection days (6 days / 34
days = 18%).
Suppose this company does $1 million a month in sales. Without going into the
math, this six day addition to average monthly collections results in the
company losing access to one month’s collections annually or $1 million in
cash flow. Since the company’s collections will be slowing by $1 million less
each year, it may have to borrow that amount to balance its cash flow needs.
Suppose the cost of borrowing from the bank is 8%. This company has now
traded $80,000 a year in salary and benefits savings and replaced them with
$80,000 of new borrowing costs – and it may get worse.
Now suppose this company’s credit policy states those customers with
outstanding invoices of 45 days or more will have current shipments held
until payment is made. If the number of 45-day accounts has grown by the same
18%, shipments averaging $180,000 a month (18% x $1 million) will be delayed.
Angry customers and salespeople will begin calling, the accounts receivable
staff will be restricted in their collection time because they have to handle
these calls, and the number of productive collection calls will begin to
drop. Inventory builds and the warehouse is short on space. Worst of all,
revenue begins to fall as shipments are delayed.
Finally, the company sees its turnover in collections personnel increasing.
Staff is frustrated by the increase in workloads and pressure from the top to
collect more money, faster. Perhaps some of the salespeople leave or even
worse, the company begins losing customers.
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Costs 101
-- Variable and Fixed
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There are basically two types of costs, variable and fixed.
Here’s an example to clarify the difference between these two types of costs.
Suppose a tornado destroyed a portion of your manufacturing building,
crippling your shipping and manufacturing capabilities for 90 days. Think
about the types of cost-cutting procedures you might think about taking.
- Cut back part time help
- Postpone selected inventory
purchases
- Cancel new advertising
promotion
- Outsource certain products
temporarily
These costs are considered variable because
they can be controlled to match production levels. In other words, costs that
are incurred as a direct result of producing or selling products and services
are variable. Relatively speaking, you can turn them off and on as volume
dictates.
Now think of those costs that continue in full force regardless of production
or sales levels:
- Rent
- Basic Utilities (Lights,
Heat, AC)
- Salaries/Benefits
- Bank interest payments
- Insurance
These are examples of fixed costs because
they are affected very little, if at all, by changes in production or sales
levels. From a valuation perspective, when fixed costs, as a percent of all
costs, is very high, the company is deemed “higher risk” and is typically
less attractive to buyers or investors. Companies with higher variable costs
are typically more attractive to buyers or investors since these costs can be
manipulated when unanticipated interruptions or economic slowdowns occur.
The best way to analyze any cost is as an investment. If the investment
cannot be tracked to a corresponding “return,” i.e., incremental cost savings
or incremental profit, it must be eliminated.
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Coming In
The Next Issue
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Don't miss the next
issue of Exit for Success. Our topic is:
The Break-Even Analysis
Use the link below to read previously published issues.
BizMACH is an association of highly skilled consultants, evaluation
experts and merger and acquisition specialists. We take ordinary companies
and create extraordinary value. Best of all, we only work with lower
mid-market companies.
Competitive advantage is the key to revitalizing your company's growth and
profitability. Call us if you'd like a free consultation and to learn how BizMACH
can grow your company and increase its value.
When you work with
BizMACH, you're using the BEST®.
Business Evaluation and Salability Tool
Tom Long
Solid Oak Consulting, LLC
522 South Elmwood Ave
Oak Park, IL 60304
708-524-0886
telong@solidoakconsulting.com
Executive Associate
Accredited by the Institute for Independent Business
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