Don’t Wait for Things to Get Tough to Improve Your Bottom Line
A dollar earned versus a dollar saved.
We’d all like to think that sales and revenue are going to increase forever, but let’s face it, that’s not always the case. The Dow Jones Industrial Average recently took a dive of around 6.6%, leading some investors to think we could be seeing the end of the current bull market.
Whether or not that’s true, the fact is there are ups and downs in every economy. The kneejerk reaction is usually to focus on diverting resources to grow revenue. You’ll see increased ad spend, new marketing initiatives and price cuts. These efforts usually return an uptick in revenue, but it also raises the cost of acquisition.
There are other ways to protect your interests when the economy slows, or worse—becomes uncertain. One surefire way is to implement a savings strategy. The beauty of a company-wide savings initiative is the dollars saved were already earned and have an immediate and positive impact on the bottom line. That’s why, when you’re looking at profitability, it’s important to not just focus on how to increase dollars coming through the door, but on reducing costs as well.
Moving the Profitability Needle
Believe it or not, a decrease in costs can have a greater impact on your bottom line than an equal increase in sales. This is because a significant portion of your costs, known as variable costs, increase in proportion with sales, offsetting some of those earnings. Let’s take a look at the difference a change of only 3% in either revenue or costs can make on your overall profits.
For this example, we will use a fictitious company that has $10 million in revenue. Their total costs add up to $9 million. Of that total figure, let’s assume that variable costs are 70% and fixed costs are 30%.
First, we’ll look at a sales boost. When sales go up 3%, revenue goes to $10.3 million, but variable costs increase as well. This increase results in costs of ($9,000,000 + [$9,000,000 x 70% x 3%]), or $9,189,000. That leaves us with an overall profit of $1,111,000.
Now let’s look at what happens when we lower the variable costs. Again, we’ll look at an overall change of 3%. This time, the total revenue stays the same at $10 million, but costs go down to ($9,000,000 – [9,000,000 x 70% x 3%]), or $8,811,000. That leaves us with an overall profit of $1,189,000.
Remarkably, in the cost-cutting example, we end up with $78,000, or about 7%, in extra profit. That money can easily be reinvested into growing the business. If you could tell your boss there was a way to increase net profits by 7% without raising any additional revenue, imagine their reaction. Your boss would be thrilled.
Unlock Savings by Managing Costs
Now that we’ve seen the benefit of cost-reduction efforts, the question arises of where to focus your efforts to gain the most savings with the lowest amount of effort. There are two major categories of costs, fixed and variable. Fixed costs consist of things like rent, labor, and insurance. These types of expenditures are difficult to reduce without introducing some form of great hardship, so you need to look elsewhere.
One great area of focus that is often overlooked is indirect spend. Indirect spend is defined as any spending on goods or services that are not used directly in the manufacture or distribution of your product. It’s a relatively broad category that can include anything from office supplies or IT equipment to business trips and convention fees. It should come as no surprise, then, that this category can cover a wide range of expenditures.
In fact, studies have shown that indirect spend can account for up to 22% of revenue at an average organization. And yet, since it’s considered “non-strategic” spend by most, it’s often overlooked or poorly managed.
It stands to reason, then, that there are some massive savings that can be gained by carefully analyzing and managing your indirect spend categories. Fortunately, you can use the same kinds of strategies you use to manage the supply chain for direct spend on most indirect purchases as well.
One such strategy is supplier consolidation – limiting the number of suppliers you purchase from. Fewer suppliers means fewer relationships to manage, which means less time needed to manage them. Plus, there’s the added benefit that it’s easier to negotiate discounts with a higher volume of purchasing.
Another is managing contract spend. Most organizations have contracts with their big suppliers, but surprisingly, these contracts aren’t always followed. In fact, it’s been estimated that off-contract spend costs the average organization up to 12% in lost savings. That’s a lot of money you can retain simply by ensuring that your contracts are properly utilized in every buying decision. And who wouldn’t want that?
The Key to a Competitive Advantage
The reasons for carefully managing your indirect spend are clear. Best-in-class organizations experience an average of 45% lower purchasing costs related to indirect spend than their peers, and an estimated savings of 2-10% of annual third party spend. These savings can easily add up to millions in increased profit every year without a single extra dollar in sales—this alone can give you a real competitive advantage compared with your competition. An advantage that will come in handy no matter which direction the market is heading.
Peter Glenn, PMP, MBA
Peter is a Senior Level Manager and Product Manager for eRequester spend management software. He has over 9 years of experience in the spend management and procurement software industry and is a frequent writer and guest writer for eRequester and other industry sites.