Profit Enhancement Through Cost Reduction: The Time Is Now

Our federal government must reduce its expenditures. It cannot continue to spend more than it brings in. Sure, it could increase taxes to balance the budget, but this would make our companies less competitive internationally. It would also lower the standard of living for each of us. The only sane answer is a smaller government spending less and wasting less.

But federal spending is not our only problem. The current financial crisis is the result of excessive debt-fueled spending at every level - individual, business and government. The remedy is simple: spend less, waste less.

At the business level, it is not always apparent where expenses can be reduced. The accepted way to increase profit is by raising revenue, but a dollar of revenue rarely delivers a dollar of profit because it costs money to market, sell and deliver a product or service. Not so for a dollar of savings. A dollar of expense eliminated delivers a full dollar of profit.

To illustrate, let's assume your company has $2 million in revenue, a gross profit margin of 40% and operating profit of 5%. We can deduce that cost of goods consumes $800,000 per year of revenue and operating expense consumes another 55% or $1,100,000. What remains is $100,000 in operating profit (5% of revenue).

Now, let's say you implement a cost reduction plan that succeeds in reducing your cost of goods expense by two percentage points - from 40% of revenue to 38%. On $2 million in revenue, you'll put the full $40,000 on the bottom line. That's a profit increase of 40%! To deliver the same $40,000 profit increase through additional sales, you'd have to sell an additional $66,667, calculated as follows:

Additional profit desired = A* times Gross Profit Margin**

$40,000 = A x 60%

* sales needed to deliver the additional profit desired

** gross profit margin is 1 minus the cost of goods percentage

(1 - .40 = .60 or 60%)

Now, use simple algebra to solve for x as follows:

A = $40,000 / .6

A = $66,666

The above assumes you could add an additional $66,000 in revenue and hold operating expense (also known as sales, general and administrative expense) steady. But if operating expense grew so that your operating profit margin remained at 5%, you'd have to sell an additional $800,000 ($40,000/.05) to add that same $40,000 to your bottom line. That'd be a pretty tough feat for a $2 million revenue company, especially today!

What's our point?

• Don't neglect expense reduction as a means to enhance profits!
• Expense minimization is absolutely essential for running a profitable business.
• Expense reduction has a greater impact on your bottom line than increased revenue.

In recessionary economic periods, expense reduction may be the only way to improve the bottom line. But reducing expense is not as simple as saying "no" to certain expenses. The where and how are not readily apparent. So there's a technique to expense minimization.

Some companies anchor their entire competitive strategy on skilful expense minimization. They compete by being able to earn higher levels of profit than their competitors on every sale. In bad times, the difference may mean survival vs. failure. In good times, it means higher profit, which can be paid to the owners or reinvested in a way that will enhance the ability to compete and win in the future.

To be sure, you do not want to compete against a company that has a lower expense structure, especially during tough times. You want to have the lower expense structure. Over time, in good times and bad, the company with the lower expense structure (and higher profit margins) will almost always win.

This issue of The Business Owner focuses on expense reduction strategies. In fact, we're going to dedicate the entire year to expense reduction techniques and strategies.

Why are "techniques and strategies" needed? Because expense reduction is not as simple as just spending less. The techniques, when applied, will show you where to cut, how to cut, and open your eyes to what is possible. Apply them and you'll become a better company. A more profitable company. The time is now.