Cost Reduction: Setting Priorities, Where to Look First

You want to reduce cost and improve profitability, but doing so takes time. And it's not like you don't have anything else to do. So where is the low-hanging fruit? Where can your efforts produce the highest yield?

The answer is pretty simple. As cost-cutting legend Harry E. Figgie, Jr. explains in The Cost Reduction and Profit Improvement Handbook, just lay out your income statement as follows*:

PDQ Company Income Statement

* We have deviated here a bit from what Figgie presented in his book.

All we have done here is to lay out the most recent full-year income statement for PDQ in a way that shows the major expense categories. Then, next to each expense category we've listed the percentage of revenue that each consumes. For example, Material Expense consumes $1,750,000 of total revenue of $3,800,000. By dividing $1,750,000 by $3,800,000 we get 46%.

Dollars of Expense/Total Revenue   =   Percentage of Revenue

$1,750,000/$3,800,000   =   46%

So pull out your income statement and organize it this way. Or ask your accountant to do it. Once you have it in front of you, consider this: You have brought in X dollars of revenue. A pretty big number, huh? Now scan down and see where all that money goes. Finally, what is left over at the end? Not much!

In the case of PDQ, $3.8 million comes in each year, but after it runs the gauntlet of outstretched hands, just $182,000 - a mere 5% of every dollar - remains. So it's plain to see who wins here - the pilferers. The vendors.

But no more. Today we fight back, and we start where the greatest amount of ground can be captured. In the case of PDQ, it's Material Expense by a landslide. Material Expense consumes 46% of every dollar of revenue. Reduce this expense by 10% and you've put an additional $175,000 on the bottom line.

Think it's not possible? Think again.

Future issues of The Business Owner Journal will provide techniques for reducing the "cost of goods" expense, but the purpose of this article is to provide a technique for identifying where to focus your cost-cutting energies at the outset of your expense reduction campaign.

Again, in the case of PDQ, here's its priority ranking:

1. Material Expense (consumes 46% of every dollar)
2. General and Administrative Expense (consumes 25% of every dollar)
3. Direct Overhead (consumes 9% of every dollar)
4. Marketing and Selling Expense (consumes 8% of every dollar)
5. Direct Labor (consumes 7% of every dollar)

Material Expense provides the low-hanging fruit, followed by General and Administrative Expense. Again, if you can reduce Material Expense 10%, your effort yields $175,000 and nearly doubles the bottom line. In the same vein, if you focus on reducing Direct Labor costs and succeed in reducing them 10%, you've generated $25,000 in additional profit.

Cost Reduction vs. Growth

Every business owner should keep in mind that a dollar of expense contributes almost a full dollar to the bottom line. This is because it generally costs very little to reduce costs. Sure, maybe some management time and effort, but the expense is negligible. But a dollar of revenue added is not nearly as valuable to the business or the business owner. In the case of PDQ, just 5 cents of every dollar of revenue falls to the bottom line. PDQ management hopes to increase that to 10 or 15 cents, but so long as expenses can be reduced in a business, expense reduction will have far greater impact on the bottom line.

What kind of expense reduction is achievable in your company? Well, Figgie spent a lifetime purging companies of unnecessary expense and improving bottom-line profit. He says that a 10% across-the-board expense reduction is almost always attainable. In the case of PDQ, that's $350,000 per year added to the bottom line, boosting profit to $532K per year or 14% of revenue. Figgie says that often 20% to 30% expense reduction is achievable.