The fastest way to improve your profit is to reduce the costs in your business!
However, we need to bear in mind that this is a very limited step. If you save costs to the ultimate degree, you no longer have an operating business! Clearly there is some point below which cost cutting can damage the business rather than improve profitability.
Nevertheless, it is very often the first step undertaken by businesses and very often is undertaken without much discrimination. We often see overly simplistic cost reduction exercises where, for example, 10% of the staff are made redundant across the board without giving thought to necessary skill sets and the products and locations that we want to maintain.
This Yellow Belt article illustrates a number of cost centres that you can consider overhauling on your road to Doubling your Profit in 100 Days.
Which Costs to Target
Not all costs should be treated the same.
One group of costs could be categorised as Strategic Costs and are those that are incurred producing profit on the bottom line. In a sales organisation for example, these might be face to face sales people, but not their managers, and it might be advertising if it is working.
The second group are Non-Strategic Costs are all other costs that are necessary to run the business but will not bring in more business themselves. A whole range of administrative costs like:
- Managers of various sorts.
- Clerical staff.
- Real estate.
- Office supplies etc. can fall in this group.
Quite often a cost slashing exercise with these types of costs can be productive without damaging the business and these are therefore the ones that should be intensively focused upon.
We are going to apply the 80/20 rule quite heavily in this section of the discussion. If you are not familiar with it refresh your understanding by visiting our 80/20 Rule Menu article. There is more specific information in how to carry these analyses out in the 80/20 Business Analysis article and a bit more advanced methods using spreadsheets in the 80/20 Data Analysis article.
Waste is a term very widely used in the various optimisation methodologies like Lean.
We suggest you take the time to read though the Profit Savvy material on the sources of Waste and how to record and reduce it. For example, experts usually talk about 8 types of Waste in general and well over 20 in an office environment; which might be quite different to what you might have expected. How many types would you have guessed?
There are many sub-types within each of these so you probably have plenty of fertile areas to work in to reduce the amount of waste in your business.
Almost certainly, areas of waste will have crept into your business over time.
Waste implies inefficiencies which in turn suggests a hit to your potential profitability from increased costs, lost income and unnecessary expense.
Read up on the where and how of waste reduction starting with the 8 Types of Waste article which is the first of several.
Products to Discard
Over time, the range of products that you have on offer will grow. Not all of these are good contributors to your profit and some of them may even detract from your profit by the time you take into account such things as inventory, warehousing, sales, personnel, price discounts, time commitment and similar.
We encourage you to perform an 80/20 analysis on your full product range, or at least on categories of those products, and to sort them by their contribution to your present profit.
All things being equal, the ones that are presently making the biggest contribution to your profit are likely to continue to do so. Exceptions to this might include such things as:
- When the market for a product is saturated and further growth seems unlikely.
- When you can’t get more of the product to sell.
- If the product is comparatively new, or otherwise disadvantaged, and you still think it has room to grow.
- If the products complement some other profitable product and so should be retained.
Keep in mind, that 80% of your products probably only contribute to 20% of your profit. Therefore, cutting substantially from this weaker end of the product range you have on offer means that you will be automatically freeing up resources, such as capital and people, that can either be re-deployed to focus on the highly profitable products or can be considered for a redundancy as we discuss in following sections.
There will undoubtedly be push back from staff on some of the products you want to cut. You might even find yourself resisting axing old favourites.
If you have properly shone some light on the actual profitability of the product, you can put the onus on staff to defend why something should not be cut.
Another approach to quickly cut through the clutter of multiple products and, even more usefully, multiple product lines is to quickly place each of them onto one of four categories on the well known Boston Consulting Group Growth Share Matrix (see BCG Matrix article). In a matter of minutes you will have identified the;
- "Dogs" with low growth and profitability and should be got rid of
- "Stars" that are quite the opposite and should be nourished
- "Cash Cows" that are growing but spin of great cashflow and the
- "Question Marks" which are growing but not producing much income. Will that change and they become "Stars" or are they going to continue to drain the bank and therefore be better treated as "Dogs"
Locations to Abandon
Over time, you may have built up a number of locations from which you operate.
Each of these locations is likely to have greater or lesser profitability. Sometimes this will depend on the same criteria as mentioned above for products; ones where the market is saturated and ones that still have potential because they are new.
However, you can perform an 80/20 analysis of the locations and decide which, if any, should be terminated.
When considering locations, also consider whether other (often virtual) outlets/channels such as a website, marketing through online portals and social media can provide sufficient ‘cover’ for the territory to not need a separately staffed, physical office, at the location.
Your existing locations can also be digital. Websites and social media specialists can be quite costly and it would be timely, at this stage, to consider whether these locations are returning on this investment and contributing to your net profit.
One discipline applied to costs by high performing organisations is what is known as "Zero-based Budgeting".
Instead of just taking last year’s budget as a starting point and adding a little or taking a little away, the Zero-based Budgets are built from the ground up each year with the Managers of that Cost Centre having to demonstrate why those costs are necessary. Even if you cannot do this on an annual basis, doing it once off as part of this profit maximisation exercise will allow you to ask each Cost Centre Manager to justify their reason for a cost being there and, more importantly, to present data on why that is the case. There are a lot of web resources to help better understand this process if you Google it.
When cutting costs, you will get push-back from the Cost Centre Managers saying that the impact of these changes are unpredictable and maybe "we should go slow". If you follow that advice, you will never achieve the cost cuts that are possible. Much better to cut heavily and then restore anything that you have cut that proves to be a necessity. The only instance where you might think otherwise is in relation to making staff redundant. Not only is it unpleasant to let good people go, it is potentially difficult and uncertain to replace them with new hires later if necessary. In this instance, it is possible "the devil you know is better than the devil you don't".
One way to impose a cost saving discipline on your staff is to require that any expenditure of more than a certain amount (and make it a small amount) must be approved by you. In the short term, this makes a lot of work for you, but very quickly you get to work out the staff who are on board and present reasonable expenses to you. The staff in turn learn that it can be a painful experience taking requests for increased expenditure to a boss who is not going to sign and will probe deeply as to why this is coming to him.
Working with Suppliers
One of the easiest, and least painful, places to start a cost cutting exercise is with suppliers.
Any activity in this area can have good pay offs. For example, let’s assume that about half of your expenditure is on products purchased from suppliers. These could be Variable Costs if you manufacture or Cost of Goods Sold if you retail. If you can reduce the price you pay by 5%, you get 2.5% of that saving going immediately to your profits (50% of 5% = 2.5%)
In our example at the start of the Program, we had a case study business with 5% net profit.
The 5% price reduction mentioned here sends 2.5% straight to the bottom line profit giving you a new profit of 7.5%; a healthy 50% improvement over the current 5% profit.
We cover this topic more in our Reducing Variable Costs article.
Reduce Inventory Costs
If your business is one that relies on inventory to a greater or lesser extent, there are possibly quite substantial savings to be made with improved inventory management.
This comes from two directions;
- Firstly, you can probably reduce the total inventory you hold and thereby reduce the amount of working capital tied up in inventory. In turn, this can reduce your debt and associated interest charges.
- Secondly, stock outages can be reduced permitting you to sell more. Logic tells us that the most likely stocks to run out are the ones that are popular and therefore fast selling. Not having them in stock to meet demand is shooting yourself in your (profit) foot.
Reduce Fixed Costs
Fixed Costs or Overhead Costs are those that will exist even if the business does not hypothetically produce anything. Alternatively, they can be thought of as costs that do not vary directly with production output. They include things like office and factory space, furniture & fittings and realistically speaking include all labour other than casual labour. After all, you can’t easily vary the size of your workforce.
We will look at labour separately shortly.
In the exercises above, you may have identified some locations that you can remove from your portfolio and now is the time to begin to wind that back.
It should be a simple exercise, if you have a decent set of accounts, to rank all your fixed costs by the size of their expenditure using the 80/20 principles. It makes every sense to then focus on your highest cost items with a view to attempting to reduce them.
For example, if you are in rather more palatial working spaces than you need, perhaps you can change to a less expensive space. Typically, this can mean moving from a CBD location to a suburban one with its lower overhead costs. With much improved levels of communication available to people these days, being centrally located is not necessarily as important as it might have been a decade or more ago.
Many overhead costs will be spread across the entire company: like power and telecommunications. You may not have ever grouped them together to see the sum of expenditure in these areas. If you do, an assessment of your various suppliers, and perhaps starting a tender with these company-wide costs, may lead to better prices and therefore savings that go straight to your profit bottom line.
Research & Development Costs (R&D)
R&D costs are an issue to address if you have any significant amount of money expended in this way.
Scientists may have difficulty explaining to you in "English" about why the project is important and why the costs are necessary. Push hard for a pragmatic analysis of what the research will produce, its probability of success and the likely income benefits.
Don’t let the scientists do this alone as they are likely oblivious to the market’s demand for their innovations. Involve marketing and other staff in a reality check of each project.
Scientists are often very pragmatic. Therefore once they are over their initial shock and horror, they may be quite positive or at worse neutral about the review project.
R&D can be loosely broken up into 5 categories:
- Pure or basic R&D, for example, nuclear fission.
- New product R&D, for example, a new hair shampoo.
- Improvement to existing products.
- Process R&D which will work on saving you manufacturing costs in your production line.
- Customer R&D where your scientists are working to better understand the customer and how to make more sales to them.
It doesn't take much to realise that most of your R&D effort will be most profit-productive in numbers 3 to 5 and somewhat in number 2. Number 1, pure R&D, is much less important unless you can see a very valuable patent coming out of it.
Reduce People Costs
Earlier on we wrote about the importance of having "the right people on the bus". By this point in this article, you have decided what products and what locations you want to retain and consequently will have identified products and locations that you no longer need. There will be personnel attached, either directly or indirectly, to producing and selling these products and to staffing the services that run out of soon-to-be redundant locations.
Staff are typically 50% - 70% of a businesses’ overhead costs. To reduce products or locations and not reduce staff is to miss out on a very considerable portion of the possible cost savings.
Savings are not only limited to very large companies. Take a small company, with (say) a 10% profit margin and staff representing 12% of the total company costs. A 25% (1/4) reduction in staff, gives around an extra 3% (12% * 25%) profit to the existing 10% or an improvement of 30% in profits.
Parkinson's Law (see Parkinson's Law article) tells us that "work will expand to fill the time available". This effectively means that there is almost certainly work being done by staff that doesn't add a great deal of value to the business. Reducing the number of staff effectively takes out some of this hidden surplus capacity and the remaining staff do not necessarily need to work harder; just smarter by selecting what work really does need to be done.
People experienced in rationalising staff numbers say that in most white-collar organisations up to 1 person in 4 can be made redundant without any reduction in worthwhile output. Sometimes this can be as high as 1 in 3 or 1 in 2.
The reason for this is:
- Much of the work is unnecessary (Parkinson's Law).
- Much of the necessary work is done inefficiently (see our Multi-tasking article).
- In almost any organisation the poorest performing 25% of people simply aren't very good at what they do and are not adding much value.
By pruning these people early, their salaries are saved. These are typically 60% of a services businesses costs. The remaining employees know the ones going are loafers and/or pests and so are heartened by the fact that they no longer carry these poor contributors. Nevertheless, you need to manage the downsizing process carefully because people will always assume the worst and will quickly start to worry that they are "next for the axe"
Down-sizing staff is a very emotionally charged activity and requires a good understanding of the relevant legislation so that you do not find yourself in hot water.
If there are several people to be made redundant, you might want to consider hiring specialist talent to do this. They are likely to be:
- Better at it than you are because they do it for a living.
- Able to save the distraction of your other management resources in a one-off exercise.
- Able to reduce the psychic damage on the managers that you are retaining from having to let people go.
- Aware of the necessary legislation and follow that correctly.
For more on Redundancy Planning see our Redundancy Planning article.
Another type of HR cost you can study for savings is the amount of overtime being paid. If this number is high and/or if creeping up, there might be some new inefficiencies (Waste) in the system. Or staff might have slowed down; either due to increased complexity or in order to earn more.
If you pay bonuses, it might be a good time to re-calibrate them to the present reality. Over time, some systems can improve so it could be that bonus staff should have higher thresholds to compensate for an easing of their work conditions.
So Much to Do, So Little Time
Like everything else in DP100, there is a lot of potential homework here and it might seem overwhelming.
But remember, you have 100 days to work your way through and you can start with the easiest / most attractive / most productive stuff first and slowly work your want through.
Take a deep breath!
So far, we have been looking at how to save costs.
This is by far the fastest way to increase your profit but it has two major limitations:
- It can only be done once in a while and so can’t make a regular contribution to boosting your profit.
- How deeply you can cut costs is limited. You can’t cost cut your way to growth.
We are now turning our thoughts to the far more exciting opportunities to grow your business. These are open ended and you can continue to tune them, and your profits, indefinitely.
We have grouped them in the discussion on increasing revenue in A2.4 DP100-Increase Revenue
DP100 is divided into several articles to be more accessible for you. These are;
- A2.1 Introduction
- A2.2 Getting Ready - how to prepare
- A2.3 Cost Reduction - the fastest step so probably where you will start (You are here)
- A2.4 Increase Revenue - without making many changes to what you presently have, it is likely you can increase revenue. Options are discussed here
- A2.5 Blue Belt - Advanced Profit Growth Techniques